ICAI Notes 3.1 - Theory of Production CA Foundation Notes | EduRev

Economics for CA CPT

Created by: Aditi Mittal

CA Foundation : ICAI Notes 3.1 - Theory of Production CA Foundation Notes | EduRev

The document ICAI Notes 3.1 - Theory of Production CA Foundation Notes | EduRev is a part of the CA Foundation Course Economics for CA CPT.
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Learning Objectives
 know the meaning of production in Economics.
 know about the various factors of production.
 understand the difference between short run and long run.
 have an insight into the laws of variable proportion and returns to scale.
 understand economies and diseconomies of sale.


Production is a very important economic activity. The standard of living in the ultimate analysis, depends on the volume and variety of goods and services produced in a country. In fact, the performance of an economy is judged by the level of its production. Those countries which produce goods in large quantities are rich and those which produce little of them are poor. Thus, the amount of goods and services an economy is able to produce determines the richness or poverty of that economy. The U.S.A. is a rich country just because its level of production is high. India is not so because its level of production is not very high.

What exactly do we mean by production in Economics? In common parlance the term ‘production’ is used for an activity of making something material. The growing of wheat, rice or any other agricultural crop by farmers and manufacturing of cloth, radio-sets, wool, machinery or any other industrial product is often referred to as production. But in Economics the word ‘production’ is used in a wider sense. In Economics, by production we mean the process by which man utilises or converts the resources of nature, working upon them so as to make them satisfy human wants. In other words, production is any economic activity which is directed towards the satisfaction of the wants of the people by converting physical inputs into the physical output. Whether it is the making of material goods or providing any service, it is included in production provided it satisfies the wants of some people. So, in Economics, if making of cloth by an industrial worker is production, the service of the retailer who delivers it to consumers is also production. Similarly, the work of doctors, lawyers, teachers, actors, dancers, etc. is production since the services are provided by them to satisfy the wants of those who pay for them. The satisfying power of goods and services is called utility. Production can also be defined as creation or addition of utility.

According to James Bates and J.R. Parkinson “ Production is the organized activity of transforming resources into finished products in the form of goods and services; and the objective of production is to satisfy the demand of such transformed resources”.

It should be noted that production should not be taken to mean as creation of matter because according to the fundamental law of science man cannot create matter. What a man can do is only to create or add utility. When a man produces a table, he does not create the matter of which the wood is composed. He only transforms wood into a chair. By doing so he adds utility to the goods.

The money expense incurred in the process of production, i.e., transforming resources into finished product constitutes the cost of production.

Production consists of various processes to add utility to natural resources for gaining greater satisfaction from them by :

(i) Changing the form of natural resources. Most manufacturing processes consist of taking raw material and transforming them into some items possessing utility, e.g., changing the form of a log of wood into a table or changing the form of iron into a machine. This may be called conferring utility of form.

(ii) Changing the place of the resources, from the place where they are of little or no use to another place where they are of greater use. This utility of place can be obtained by :

(a) extraction from earth e.g., removal of coal, minerals, gold and other metal ores from mines and supplying them to markets.

(b) transferring goods from where they give little or no satisfaction, to places where their utility is more, e.g., tin in Malaya is of little use until it is brought to the industrialised centres where necessary machinery and technology are available to produce metal boxes for packing.  Another example is : apples in Kashmir orchards have some use to farmers. But when the apples are transported to markets where human settlements are thick and crowded like the city centres, they afford more satisfaction to greater number of people, rather than to the farmers in the Kashmir apple orchards.

These examples only emphasise the additional utility conferred on all goods, by all forms of transportation systems, by transport workers and by the agents who assist in the movement and marketing of goods.

(iii) Making available materials at times when they are not normally available e.g., harvested foodgrains are stored for use till next harvest. Canning of seasonal fruits is undertaken to make them available during off season. This may be called conferring of utility of time.

(iv) Making use of personal skills in the form of services, e.g., those of organisers, merchants, transport workers etc.

The fundamental purpose of all these activities is same, namely to create utility in some manner. So production is nothing but the creation of utilities in the form of goods and services. For example, in the production of a woollen suit utility is created in some form or the other. Firstly wool is changed into woollen cloth at the spinning and weaving mill (utility created by changing the form). Then it is taken to a place where it is to be sold (utility added by transporting it). Since woollen clothes are used in winter they will be retained until such time when they are required by purchasers (time utility). In the whole process, services of various groups of people are utilised (as that of mill workers, shopkeepers, agents etc.) to contribute to the enhancement of utility. Thus the entire process of production is nothing but creation of form utility, place utility, time utility and/or personal utility.


The process of producing goods in the modern economy is very complex. A good has to pass through many stages and many hands until it reaches the consumer’s hands in a finished form. Land, labour, capital and entrepreneurial ability are all the factors or resources which make it possible to produce goods and services. Even a small piece of bread cannot be produced without the active participation of these factors of production. While land is a free gift of nature and refers to natural resources, the human endeavour is classified functionally and qualitatively into three main components namely labour, capital and entrepreneurial skills.

We may discuss these factors of production briefly in the following paragraphs.

1.1.0 Land : The term ‘land’ is used in a special sense in Economics. It does not mean soil or earth’s surface alone but refers to all free gifts of nature which would include besides the land, in common parlance, natural resources, fertility of soil, water, air, natural vegetation etc. It becomes difficult at times to state precisely to what part of a given factor is due solely to the gift of nature and what part belongs to human effort made on it in the past. Therefore, as a theoretical concept, we may list the following characteristics which would qualify a given factor to be called land :

(i) Land is a free gift of nature. It is neither created nor destroyed by man.

(ii) Land is strictly limited in quantity. It is different from the other factors of production in that, for practical purposes, it is permanently in being; no change in demand can affect the amount of land in existence. In other words, the supply of land is perfectly inelastic from the point of view of the economy. However, it is relatively elastic from the point of view of a firm.

(iii) According to Ricardo, the production power of soil is indestructible in the sense that the properties of the land cannot be destroyed. Even if its fertility gets depleted it can be restored.

(iv) Land cannot be shifted from one place to another place. The natural factors typical to a given place cannot be shifted to other places. It may, however be noted that man has been able to shift water from one place to another e.g. Rajasthan Canal. Land can however, be used for varied purposes though its suitability in all the uses is not the same.

(v) Land is said to be a specific factor of production in the sense that it does not yield any result unless human efforts are employed. Land varies in fertility and uses.

1.1.1 Labour : The term ‘labour’, means mental or physical exertion directed to produce goods or services. In other words, it refers to various types of human effort which require the use of physical exertion, skill and intellect. It is, however, difficult to say that in any human effort all the three are not required; the proportion of each might vary. Labour, to have an economic significance, must be one which is done with the motive of some economic reward. Anything done out of love and affection, although very useful in increasing human well-being, is not labour in the economic sense of the term. It implies that any work done for the sake of pleasure or love does not represent labour in Economics. It is for this reason that the services of a housewife are not treated as labour, while those of a maid servant are treated as labour. If a person sings before his friends just for the sake of pleasure, it does not mean labour despite the exertion involved in it. On the other hand, if a person sings against payment of some fee, then this activity signifies labour.

Characteristics of labour : 

(1) Labour, as compared with other factors is different. It is connected with human efforts whereas others are not directly connected with human efforts. As a result of this, there are certain human and psychological considerations which may come up unlike in the case of other factors.

(2) Labour is highly ‘perishable’ in the sense that a day’s labour lost cannot be completely recovered because the expenditure on maintenance has to be there. Whatever is lost in a day cannot be recovered wholly by extra work next day. In other words, a labourer cannot store his labour and so he has no reserve price for his labour.

(3) Labour is inseparable from the labourer himself. It implies that whereas labour is sold, the producer of labour retains the capacity to work. Thus, a labourer is the source of his own labour power.

(4) Labour power differs from labourer to labourer. On the basis of labour power a labour may be classified as unskilled labour, semi-skilled labour and skilled labour. Labour power depends upon physical strength, education, skill and upon the motivation to work.

(5) All labour is not productive in the sense that all efforts are not sure to produce resources.

(6) Labour has a weak bargaining power. It is because the labourer is economically weak while the employer is economically powerful although things have changed a lot in favour of labour during the 20th century.

(7) A labourer has to make a choice between the hours of labour and the hours of leisure. The supply of labour and wage rate are directly related. It implies that, as the wage rate increases the labourer tends to increase the supply of labour by reducing the hours of leisure. However, beyond a minimum level of income, the labourer reduces the supply of labour and increases the hours of leisure in response to further rise in the wage rate. That is, he prefers to have more of rest and leisure than earning more money.

(8) Labour is a mobile factor. Apparently, workers can move from one job to another or from one place to another. But, in reality there are many obstacles in the way of free movement of labour from job to job or from place to place.

1.1.2 Capital : We may define capital as that part of wealth of an individual or community which is used for further production of wealth. In fact, capital is a stock concept which yields a periodical income which is a flow concept. It is necessary to understand the difference between capital and wealth. Whereas wealth refers to all those goods and human qualities which are useful in production and which can be passed on for value, only a part of these goods and services can be characterised as capital because if these resources are lying idle they will constitute wealth but not capital. Capital has been rightly defined as ‘produced means of production’. This definition distinguishes capital from both land and labour because both land and labour are not produced factors. They are primary or original factors of production but capital is not a primary or original factor; it is a produced factor of production. It has been produced by man by working with nature. Therefore, capital may well be defined as man made instruments of production. Machine tools and instruments, factories, dams, canals, transport equipment etc., are some of the examples of capital. All of them are produced by man to help in the production of further goods.

Types of Capital:

Fixed capital is that which exists in a durable shape and renders a series of services over a period of time.  For example tools, machines, etc.

Circulating capital is another form of capital which performs its function in production in a single use and not available for further use. For example, seeds, raw material, etc.

Real capital refers to physical goods such as building, plant, machines, etc.

Human capital refers to human skill and ability. This is called human capital because a good deal of investment has gone into creation of these abilities in humans.

Tangible capital can be perceived by senses whereas intangible capital is in the form of certain rights and benefits which cannot be perceived by senses. For example, goodwill, patent rights, etc.

Individual capital is the personal property owned by an individual or a group of individuals.

Social Capital is what belongs to the society as a whole in the form of roads, bridges, etc.

Capital formation : Capital formation means a sustained increase in the stock of real capital in a country. In other words, capital formation involves production of more capital goods like, machines, tools, factories, transport equipment, electricity etc. which are all used for further production of goods. Capital formation is also known as investment. The need for capital formation or investment is realised not merely for replacement and renovation but for creating additional productive capacity. In order to accumulate capital goods, some current consumption is to be sacrified and savings of current income are to be made. Savings are also to be channelised into productive investment. The greater the extent that people are willing to abstain from present consumption the greater the extent of savings and investment that society will devote to new capital formation. If society consumes all what it produces and saves nothing, future productive capacity of the economy will fall as the present capital equipment wears out. In other words, if the whole of the current present capacity is used to produce consumer goods and no new capital goods are made, production of consumer goods in the future will greatly decline. It is prudent to cut down some of the present consumption and direct part of it to the making of capital goods such as tools and instruments, machines and transport facilities, plant and equipment etc.. They will not only increase the efficacy of production efforts but also will make possible the expansion of output of consumer goods in the future.

Stages of capital formation : There are mainly three stages of capital formation which are as follows :

1. Savings : The basic factor on which formation of capital depends is the ability to save. The ability to save depends upon the income of an individual. Higher incomes are generally followed by higher savings. This is because with an increase in income the propensity to consume comes down, and the propensity to save increases. This is true not only for an individual but also for the economy as a whole. A rich country has greater ability to save and thereby can get richer quickly compared to a poor country which has no ability to save and therefore has limited capacity for growth in national income given the capital output ratio.

It is not only the ability to save but willingness to save which counts a great deal. Willingness depends upon the individual’s concern about his future as well as upon the social set-up in which he lives. If an individual is farsighted and wants to make his future secure he will save more. Moreover, the government can enforce compulsory savings on the people by imposing taxes. In recent years, business community’s savings and government’s savings are also becoming important.

2. Mobilisation of savings : It is not enough that people save money; what is required is that the saved money enters into circulation and facilitates the process by capital formation. There should be a wide spread network of banking and other financial institutions to collect public savings and take them to prospective investors. In this process, the state has a very important and positive role to play both in generating saving through various physical and monetary incentives and channelisation of the savings towards priority needs of the community so that there is not only the capital generation but socially beneficial type of capital formation.

3. Investment : The process of capital formation get completed only when the real savings get converted into real capital assets. An economy should have a entrepreneurial class which is prepared to bear the risk of business and invest savings in productive avenues so as to create new capital assets.

1.1.3 Entrepreneur : Having explained three factors namely land, labour and capital, we now turn to the explanation of the fourth important factor, namely, the entrepreneur. It is not enough to say that production is a function of land, capital and labour. There must be some factor which mobilises these factors, combines in the right proportion, then initiates the process of production and bears the risk involved in it. This factor is known as the entrepreneur. He has also been called the organiser, the manager or the risk taker. But in these days of specialisation, the task of manager or organiser has become different from that of the entrepreneur. While organisation and management involve decision-making of routine and non-routine types, the task of the entrepreneur is to initiate production work and to bear the risk involved in it. 

Functions of an entrepreneur : An entrepreneur performs the following functions in general :

(i) Initiating a business enterprise and resource co-ordination : The first and the foremost function of an entrepreneur is to initiate a business enterprise. For this, he has to collect different factors of production such as labour, capital, land or factory building and bring about co-ordination among them. These various other factors of production are paid fixed contractual remuneration : labour at fixed rate of wages, land or factory building at a fixed rent for its use and capital at a fixed rate of interest. The surplus, if any, after all the fixed costs and variable costs are met, accrues to the entreprenuer as his reward for his efforts and risk-taking. Thus the reward for an entrepreneur, that is a profit, is not fixed. He may earn profits, or incur losses. Other factors get their payment irrespective of whether the entrepreneur makes profits or losses.

(ii) Risk bearing or uncertainty bearing : The ultimate responsibility for the success and survival of business lies with the entrepreneur. What is planned and anticipated by the entrepreneur may not come true and the actual course of events may differ from what was anticipated and planned. The economy is dynamic and changes occurr everyday. The demand for a commodity, the cost structure, fashions and tastes of the people, and government’s policy regarding taxation, credit, interest rate etc. may change. All these changes bring about changes in the cost or demand conditions of a business firm. It may happen that as a result of certain broad changes which were not anticipated by the entrepreneur the firm has to incur heavy losses. Thus, the entrepreneur has to bear these financial risks. Apart from financial risks, the entrepreneur also faces technological risks which arise due to the inventions and improvement in techniques of production, making the existing techniques and machines obsolete. The entrepreneur has to assess and bear the risks. These risks are different from the risks like risks of fire, theft, burglary etc. which can be insured against. These risks which cannot be insured are also called uncertainties and the entrepreneur earns profits because he bears uncertainty in a dynamic economy where changes occur everyday.

Innovations : One of the important functions of an entrepreneur is to introduce innovations. Innovations in a very broad sense include the introduction of new or improved production methods, utilisation of new or improved source of raw-material, adoption of new or improved forms of organisation, introduction of a new or improved product, opening of new or improved markets. According to Schumpeter, the task of the entrepreneur is to continuously introduce new innovations.


Production function states the relationship between inputs and output i.e., the maximum amount of output that can be produced with given quantities of inputs under a given state of technical knowledge. It can also be defined as the minimum quantities of various inputs that are required to yield a given quantity of output. The output takes the form of volume of goods or services and the inputs are the different factors of production i.e., land, labour, capital and enterprise.

Production Function: In short, the production function is a catalogue of output possibilities. The production function can be algebraically expressed in an equation in which the output is the dependent variable and inputs are the independent variables. The equation can be expressed as: q = f (a, b, c, d …….n) where ‘q’ stands for the rate of output of given commodity a, b, c, d…….n, are different factors (inputs) and services used per unit of time.

The production function of a firm can be studied in the context of short period or long period. Short period or short run is that period of time which is too short for a firm to install a new capital equipment to increase production. It implies capital is a fixed factor in the short run and the production function is studied by holding the quantities of capital fixed, while varying the amount of other factors (labour, raw material etc.) Symbolically, Q = T (K, L). This is done when the law of variable proportion is derived. The production function can also be studied in the long run. The long run is a period of time (or planning horizon) in which all the factors of production are variable. It is a time period when the firm will be able to install new machines and capital equipments apart from increasing the units of labour. The behaviour of production when all factors are varied is the subject matter of the laws of returns to scale.

Assumptions of Production Function: 

The production function is based on the certain assumptions;

1. It is related to a particular unit of time.

2. The technical knowledge during that period of time remains constant.

3. The factors of production are divisible into most viable units.

4. The producer is using the best technique available.

Cobb-Douglas Production Function 

A famous statistical production function is Cobb-Douglas production function. Paul H. Douglas and C.W. Cobb of the U.S.A. studied the production function of the American manufacturing industries. In its original form, this production function applies not to an individual firm but to the whole of manufacturing in the United States. In this case, output is manufacturing production and inputs used are labour and capital.

Cobb-Douglas production function Q = KLa C(1-a) where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital. ‘K’ and ‘a’ are positive constants.

The conclusion drawn from this famous statistical study is that labour contributed about 3/4th and capital about 1/4th of the increase in the manufacturing production. The function is linear and homogeneous. It shows constant returns to scale.

1.2.1 Law of variable proportions : Before discussing this law, if would be appropriate to understand the meaning of total product, average product and marginal product.

Total Product (TP) : Total product is the total output resulting from the efforts of all the factors of production combined together at any time. If the inputs of all but one factor are held constant, total product will vary with the quantity used of the variable factor. Column (1) and (2) of Table 1 represent a total product schedule.

Table 1 : Product Schedule

Quantity of labour

Total Product 


Average Product 


Marginal Product




We find that when one unit of labour is employed, the total product is 100 units. When two units of labour are employed, the total product rises to 210 units. The total product goes on rising as more and more units of labour are employed. With 10 units of labour, the total product rises to 760 units. When 11 units of labour are employed, total product falls to 740 units.

Average Product (AP) : Average product is the total product per unit of the variable factor. It is shown as a schedule in column (3) of Table 1. When one unit of labour is employed, average product is 100, when two units of labour are employed, average product rises to 105. This goes on, as shown in Table 1.

Marginal Product (MP) : Marginal product is the change in total product per unit change in the quantity of variable factor. In other words, it is the addition made to the total production by an additional unit of input. The computed value of the marginal product appears in the last column of Table 1.

For example, the MP corresponding to 4 units is given as 100 units. This reflects the fact that an increase in labour from 3 to 4 units increased output from 330 to 430 units.

Relationship between Average Product and Marginal Product : Both average product and marginal product are derived from the total product. Average product is obtained by dividing total product by the units of variable factor and marginal product is the change in total product resulting from a unit increase in the quantity of variable factor. The various points of relationship between average product and marginal product can be summed up as follows :

(i) when average product rises as a result of an increase in the quantity of variable input, marginal product is more than the average product. 

(ii) when average product is maximum, marginal product is equal to average product. In other words, the marginal product curve cuts the average product curve at its maximum.

(iii) when average product falls as a result of a decrease in the quantity of variable input, marginal product is less than the average product.

Table 1 and Figure 1 confirm the above points of relationship.

The law of variable proportions or the law of diminishing returns examines the production function with one factor variable, keeping quantities of other factors fixed. In other words, it refers to input-output relationship, when the output is increased by varying the quantity of one input. This law operates in the short run ‘when all the factors of production cannot be increased or decreased simultaneously (for example, we cannot build a plant or dismantle a plant in the short run). The law operates under certain assumptions which are as follows :

1. The state of technology is assumed to be given and unchanged. If there is any improvement in technology, then marginal and average product may rise instead of falling.

2. There must be some inputs whose quantity is kept fixed. This law does not apply to cases when all factors are proportionately varied. When all the factors are proportionately varied, laws of returns to scale are applicable.

3. The law does not apply to those cases where the factors must be used in fixed proportions to yield product. When the various factors are required to be used in fixed proportions, then an increase in one factor would not lead to any increase in output i.e., marginal product of the variable factor will then be zero and not diminishing.

4. We consider only physical inputs and outputs and not economic profitability in monetary terms.

The law states that as we increase the quantity of one input which is combined with other fixed inputs, the marginal physical productivity of the variable input must eventually decline. In other words, 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 addition of extra inputs will become less and less.

The behaviour of output when the varying quantity of one factor is combined with a fixed quantity of the others can be divided into three distinct stages or laws. In order to understand these three stages or laws, we may graphically illustrate the production function with one factor variable. This is done in Figure 1.

In this figure the quantity of variable factor is depicted on the X axis and on the Y-axis is measured the Total Product (TP), Average Product (AP) and Marginal Product (MP). As the figure shows TP curve goes on increasing to a point and after that it starts declining. AP and MP curves first rise and then decline; MP curve starts declining earlier than the AP curve. The behaviour of these Total, Average and Marginal Products of the variable factor consequent on the increase in its amount is generally divided into three stages (laws) which are explained below.

ICAI Notes 3.1 - Theory of Production CA Foundation Notes | EduRev

Fig. 1 : Law of variable proportions

Stage 1 : The Law of Increasing Returns : In this stage, total product increases at an increasing rate upto a point (in figure upto point F), marginal product also rises and is maximum at the point F and average product goes on rising. From point F onwards during the stage one, the total product goes on rising but at a diminishing rate. Marginal product falls but is positive. The stage 1 ends where the AP curve reaches its highest point.

Thus in the first stage the AP curve rises throughout whereas marginal product curve first rises and then start falling after reaching its maximum. It is to be noted that the marginal product although starts declining, remains greater than the average product throughout the stage so that average product continues to rise.

Explanation of the law : The law of increasing returns operates because in the beginning the quantity of fixed factors is abundant relative to the quantity of the variable factor. As more units of variable factor are added to the constant quantity of the fixed factors then the fixed factors is more intensively and effectively utilised i.e., the efficiency of the fixed factors increases as additional units of the variable factors are added to it. This causes the production to increase at a rapid rate. For example, if a machine can be efficiently operated when four persons are working on it and if in the beginning we are operating it only with three persons, production is bound to increase if the fourth person is also put to work on the machine since the machine will be effectively utilised to its optimum. This happens because in the beginning some amount of fixed factor remained unutilised and, therefore, when the variable factor is increased, fuller utilisation of the fixed factor becomes possible and it results in increasing returns. A question arises as to why the fixed factor is not initially taken in a quantity which suits the available quantity of the variable factor. The answer is that generally those factors are taken as fixed which are indivisible. Indivisibility of a factor means that due to technological requirements a minimum amount of that factor must be employed whatever the level of output. Thus as more units of the variable factor are employed to work with an indivisible fixed factor, output greatly increases due to fuller utilisation of the latter. The second reason why we get increasing returns at the initial stage is that as more units of the variable factors are employed, the efficiency of the variable factors itself increases. This is because with sufficient quantity of variable factor introduction of division of labour and specialisation becomes possible which results in higher productivity.

Stage 2 : Law of diminishing returns : In stage 2, total product continues to increase at a diminishing rate until it reaches its maximum point H, where the second stage ends. In this stage both marginal product and average product of the variable factor are diminishing but are positive. At the end of this stage i.e., at point M (corresponding to the highest point H of the total product curve), the marginal product of the variable factor is zero. Stage 2, is known as the stage of diminishing returns because both the average and marginal products of the variable factors continuously fall during this stage. This stage is very important because the firm will seek to produce in its range.

Explanation of the law : The question arises as to why we do get diminishing returns after a certain amount of the variable factor has been added to the fixed quantity of that factor. As explained above increasing returns occur primarily because of the more efficient use of fixed factors as more units of the variable factor are combined to work with it. Once the point is reached at which the amount of variable factor is sufficient to ensure efficient utilisation of the fixed factor, then further increases in the variable factor will cause marginal and average product to decline because the fixed factor then becomes inadequate relative to the quantity of the variable factor. Continuing the above example, when four men were put to work on one machine, optimum combination was achieved. Now if the fifth person is put on the machine, his contribution will be nil. In other words the marginal productivity will start diminishing. The phenomenon of diminishing returns, like that of increasing returns rests upon the indivisibility of the fixed factor. Just as the average product of the variable factor increases in the first stage when better utilisation of the fixed indivisible factor is being made, so the average product of the variable factor diminishes in the second stage when the fixed indivisible factor is being worked too hard. Another reason offered for the operation of the law of diminishing returns is the imperfect substitutability of one factor for one another. Had the perfect substitute of the scarce fixed factor been available, then the paucity of the scarce fixed factor during the second stage would have been made up by increasing the supply of its perfect substitute with the result that output could be expanded without diminishing returns.

Stage 3 : Law of negative returns : In Stage 3, total product declines, MP is negative, average product is diminishing. This stage is called the stage of negative returns since the marginal product of the variable factor is negative during this stage.

Explanation the law : As the amount of the variable factor continues to be increased to constant quantity of the other, a stage is reached when the total product declines and marginal product become negative. This is due to the fact that the quantity of variable factor becomes too excessive relative to the fixed factor so that they get in each other’s ways with a result that the total output falls instead of rising. In such a situation a reduction in the units of the variable factor will increase the total output.

Stage of operation : An important question is in which stage a rational producer will seek to produce. A rational producer will never produce in stage 3 where marginal product of the variable factor is negative. This being so a producer can always increase his output by reducing the amount of variable factor. Even if the variable factor is free of cost, the rational producer stops before the beginning of third stage.

The rational producer will also not produce in stage 1 where the marginal product of the fixed factor is negative. The producer producing in stage 1 will not be making best use of the fixed factor and he will not be utilising fully the opportunities of increasing production by increasing quantity of the variable factor whose average product continues to rise throughout stage 1. Even if the fixed factor is free of cost in this stage, the rational entrepreneur will continue adding more variable factors. It is thus clear that a rational producer will never produce in stage 1 and stage 3. These stages are called stages of economic absurdity or economic non-sense.

A rational producer will always produce in stage 2 where both the marginal product and average product of the variable factors are diminishing. At which particular point in this stage, the producer will decide to produce depends upon the prices of factors.

1.2.2 Returns to Scale : We shall now undertake the study of production in the long run. Or we will study changes in output when all factors of production in a particular production function are increased together. In other words, we shall study the behaviour of output in response to a change in the scale. A change in the scale means that all factors of production are increased or decreased in the same proportion. Changes in scale is different from changes in factor proportions. Changes in output as a result of the variation in factor proportions, as seen before, form the subject matter of the law of variable proportions. On the other hand, the study of changes in output as a consequence of changes in scale forms the subject matter of returns to scale which is discussed here.

Returns to scale may be constant, increasing or decreasing. If we increase all factors i.e., scale in a given proportion and output increases in the same proportion, returns to scale are said to be constant. Thus if a doubling or trebling of all factors causes a doubling or trebling of output, returns to scale are constant. But if the increase in all factors leads to more than proportionate increase in output, returns to scale are said to be increasing. Thus if all factors are doubled and output increases more than a double then the returns to scale are said to be increasing. On the other hand if the increase in all factors leads to less than a proportionate increase in output, returns to scale are decreasing. It is needless to say that this law operates in the long run when all the factors can be changed in some proportion simultaneously.

Constant returns to scale : As stated above, constant returns to scale means that with the increase in the scale in some proportion, output increases in the same proportion. It has been found that production function for the economy as a whole corresponds to production function exhibiting constant returns to scale. Also, it has been found that an individual firm passes through a long phase of constant returns to scale in its lifetime. Constant return to scale is other wise called as “Linear Homogeneous Production Function”. 

ICAI Notes 3.1 - Theory of Production CA Foundation Notes | EduRev

Fig. 2 : Linear Homogeneous Production Function

Increasing returns to scale : As stated earlier increasing returns to scale means that output increases in a greater proportion than the increase in inputs. When a firm expands, increasing returns to scale are obtained in the beginning. For example, a wooden box of 3 ft. cube contains 9 times greater wood than the wooden box of 1 foot-cube. But capacity of the 3 foot- cube box is 27 times greater than that of one foot cube. Many such examples are found in real world. Another reason for increasing returns to scale is the indivisibility of factors. Some factors are available in large and lumpy units and can, therefore, be utilised with utmost efficiency at a large output. If all the factors are perfectly divisible, increasing returns may not occur. Returns to scale may also increase because of greater possibilities of specialisation of land and machinery.

ICAI Notes 3.1 - Theory of Production CA Foundation Notes | EduRev

Fig. 3 : Increasing Return to Scale

Decreasing returns to scale : When output increases in a smaller proportion with an increase in all inputs, decreasing returns to scale are said to prevail. When a firm goes on expanding by increasing all inputs, then finally diminishing returns to scale set in. Decreasing returns to scale eventually occur because of increasing difficulties of management, coordination and control. When the firm has expanded to a very large size it is difficult to manage it with same efficiency as previously. 

ICAI Notes 3.1 - Theory of Production CA Foundation Notes | EduRev

Fig. 4 : Decreasing Return to Scale


The Scale of Production :

In the modern days, the size of the business undertakings has greatly increased and production on a large scale is a very important feature of modern industrial society. Large-scale production offers certain advantages which help in reducing the cost of production. Economies arising out of large-scale production can be grouped into two categories; viz., internal economies and external economies. Internal economies are those economies of production which accrue to the firm when it expands the output, so that the cost of production would cone down considerably and place the firm in a better position to compete in the market effectively. Economies arise purely due to endogenous factors relating to efficiency of the entrepreneur or his managerial talents or the type of machinery used or the marketing strategy adopted. These economies arise within the firm and help the firm only. On the other hand external economies are the benefits accruing to each member firms of the industry as a result of the expansion of the industry.

Internal Economies and Diseconomies : We saw that returns to scale increase in the initial stages and after remaining constant for a while, they decrease. The question arises as to why we get increasing returns to scale due to which cost falls and why after a certain point we get decreasing returns to scale due to which cost rises. The answer is that initially a firm enjoys internal economies of scale and beyond a certain limit it suffers from internal diseconomies of scale. Internal economies and diseconomies are of following main kinds : 

(i) Technical economies and diseconomies : Large-scale production is associated with technical economies. As the firm increases its scale of operations, it becomes possible to use more specialised and efficient form of all factors, specially capital equipment and machinery. For producing higher levels of output, there is generally available a more efficient machinery which when employed to produce a large output yields a lower cost per unit of output. Secondly, when the scale of production is increased and the amount of labour and other factors become larger, introduction of a greater degree of division of labour or specialisation becomes possible and as a result cost per unit declines.

However, beyond a certain point a firm experiences net diseconomies of scale. This happens because when the firm has reached a size large enough to allow utilisation of almost all the possibilities of division of labour and the employment of more efficient machinery, further increase in the size of the plant will bring high long-run cost because of difficulties of management. When the scale of operations becomes too large, it becomes difficult for the management to exercise control and to bring about proper coordination.

(ii) Managerial economies and diseconomies : Managerial economies refer to reduction in managerial cost. When output increases, division of labour can be applied to management. The production manager can look after production, sales manager can look after sales, finance manager can look after finance department. If scale of production increases further, each department can be further sub-divided for e.g. sales can be split into sections for advertising exports and customer service. Since individual activities come under the supervision of specialists, management’s efficiency and productivity greatly improve. Decentralisation of decision making authority also becomes possible in such a firm which enhances further the efficiency and productivity of managers. Thus specialisation of management enables large firms to achieve reduction in managerial costs.

However, as scale of production increases beyond a certain limit, managerial diseconomies set in. Management finds it difficult to exercise control and bring coordination among various departments. The managerial structure becomes more complex and is affected by more bureaucracy, more red tape, lengthening of communication lines and so on. All these affect the efficiency and productivity of management and the firm itself.

(iii) Commercial economies and diseconomies : Production of big volumes of goods requires large amount of material and components. This enables the firm to place a bulk order for materials and components and enjoy lower prices for them. Economies can also be achieved in selling the product. If the sales staff is not being worked to capacity, additional output can be sold at little extra cost. Moreover, large firms can benefit from economies of advertising. As scale of production increases, advertising costs per unit of output fall. In addition, a large firm may also be able to sell its by-products-something which might be unprofitable for a small firm.

These economies become diseconomies after an optimum scale. For example, advertisement expenditure and other marketing overheads will increase more than proportionately after the optimum scale.

(iv) Financial economies and diseconomies : In raising finance for expansion large firm is in favourable position. It can, for instance, offer better security to bankers and, because it is well-known, raise money at lower cost, since investors have confidence in it and prefer shares which can be readily sold on the stock exchange. However, these financial costs will rise more proportionately after the optimum scale of production. This may happen because of relatively more dependence on external finances.

(v) Risk bearing economies and diseconomies : It is said that a large business with diverse and multi-production capability is in a better position to withstand economic ups and downs, and therefore, enjoys economies of risk bearing. However, risk may increase if diversification instead of giving a cover to economic disturbances, increases these.

External Economies and Diseconomies : The use of greater degree of division of labour and specialised machinery at higher levels of output are termed as internal economies. They are internal in the sense that they accrue to the firm due to its own efforts. Besides internal economies, there are external economies which are very important for a firm. External economies and diseconomies are those economies and diseconomies which accrue to firms as a result of expansion in the output of whole industry and they are not dependent on the output level of individual firms. They are external in the sense they accrue to firms not out of their internal situation but from outside i.e. expansion of the industry. These are available to one or more of the firms in the form of :

1. Cheaper raw materials and capital equipment : The expansion of an industry may result in exploration of new and cheaper sources of raw material, machinery and other types of capital equipment. Expansion of an industry results in greater demand for the various kinds of materials and capital equipment required by it. This makes it possible to purchase on a large scale from other industries. This reduces their cost of production and hence their prices. Thus, firms using these materials and capital equipment will be able to get them at a lower price.

2. Technological external economies : When the whole industry expands, it may result in the discovery of new technical knowledge and in accordance with that the use of improved and better machinery than before. This will change the technical co-efficient of production and will enhance productivity of firms in the industry and reduce their cost of production.

3. Development of skilled labour : When an industry expands in an area the labour in that area is well accustomed to do the various productive processes and learns a good deal from the experience. As a result, with the growth of an industry in an area a pool of trained labour is developed which has a favourable effect on the level of productivity and cost of the firms in that industry.

4. Growth of ancillary industries : With the growth of an industry, a number of ancillary industries may specialise in production of raw materials, tools and machinery etc. They can provide them at a lower price to the main industry. Likewise, some firms may get developed processing the waste products of the industry and making out some useful product out of it. This will tend to reduce the cost of production in general.

5. Better transportation and marketing facilities : The expansion of an industry resulting from entry of new firms may make possible the development of transportation and marketing network to a great extent which will greatly reduce cost of production of the firms. Similarly, communication system may get modernised resulting in better and speedy information.

However, external economies may also cease if there are certain disadvantages which may neutralise the advantages of the expansion of an industry. We call them external diseconomies. An example of external diseconomies is the rise in some factor prices. When an industry expands, the requirement of the various factors of production increases; for example, that of all raw materials, capital goods, skilled labour and so on. This may result in pushing up the prices of such factors of production specially when they are short in supply. Moreover, too many firms in an industry at one place may also result in higher transportation cost, marketing cost and high pollution control cost. The government may also through its locational policy prohibit or restrict expansion of an industry at a particular place.


Production means creation or addition of utility. Production does not include domestic work, voluntary services, leisure time activities etc. For the production process to work, there must exist factors with which to produce goods and services. Factors of production are classified as land, labour, capital and entrepreneur. Land includes all those natural resources whose supply for the economy as a whole is fixed. Labour is any mental or physical exertion directed to produce goods or services. Capital is a produced means of production and it comprises manmade machines and materials which are used for further production. Entrepreneur is the person who bears the risk and uncertainties of business.

Factors of production can be divided into two categories - fixed factors and variable factors. Fixed factors are those factors whose quantity remains unchanged in the short run. Variable factors change with a change in the level of output. The production level can be changed by changing the factor proportions in which variable factors are used. The production-scale can be changed by changing all factors together. When some factors are kept fixed and others are varied, the law of variable proportions (or law of diminishing returns) is applicable. The law states that as increased quantities of one factor are combined with other fixed factors, marginal physical productivity of the variable input must eventually decline. The law of variable proportions is applicable in the short-run. In the long-run, all factors are variable and thus they can be varied easily. When this is done, we may have increasing, constant or diminishing returns to scale. Returns to scale occur due to economies of scale. Economies of scale are of two kinds - external economies of scale and internal economies of scale. External economies of scale accrue to a firm due to factors which are external to it and internal economies of scale accrue to a firm when it engages in large scale production. Increase in scale, beyond the optimum level, results in diseconomies of scale.    

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