Law of Increasing Returns: Assumptions, Explanation and Causes

Law of Increasing Returns: Definitions, Assumptions, Explanation, Causes and Similarities and Dissimilarities! 

The Law of Increasing Returns was propounded in the seventeenth century by Antonia Seera. This law is nothing but an improvement over the law of diminishing returns.

According to this law, “Production of a commodity increases in a larger proportion as compared to the increase in the units of factors of production.” For instance, we want to increase the production of shoes.

The producer increases factors of production by 20 per cent and as a result the production of shoes increases by 35 per cent.

Thus, we can say that the production of shoes obeys the Law of Increasing Returns. This law is also known as the Law of Diminishing Costs. It means cost per unit of the extra output falls as the industry expands.

Definitions:

“An increase of labour and capital leads generally to improved organization, which increases the efficiency of the work of labour and capital. Therefore, an increase of labour and capital generally gives returns which increases more than in proportion.” Marshall

“As the production of one factor in a combination of factors is increased up to a point, the marginal productivity of the factors will increase.” Benham

Assumptions:

The law of increasing returns is based on the following assumptions:

1. Some factors of production should be divisible or variable.

2. Arrangement of fixed as well as variable factors can be made more effective

3. At least one factor of production is divisible.

Explanation of the law:

The present law can be explained in two forms i.e:

(i) Law of Increasing Returns and

(ii) Law of Diminishing Costs.

(i) Law of Increasing Returns:

Table 4 shows that one unit of labour and capital yields the total production of 4. If one additional unit is employed, total production increases to 10. The marginal production of the second unit will be 6 (10-4) and average production will be 5. Likewise the employment to third unit of capital and labour will raise the production to 5. Likewise the employment of third unit of capital and labour will raise the marginal production to 8 and average production to six.

The marginal and average production of the fourth unit will be 10 and 7 respectively. The fifth unit will raise the marginal production to 12 and average production to 8. Thus, it shows that both marginal and average production increase as a result of the increase in the factors of production.

This law can be illustrated with the help of diagram 4. In this diagram units of capital and labour are shown along OX-axis and OY expresses the marginal production. Curve IR shows the increasing returns. This curve rises upward from left to right. It shows that marginal production will increase as the units of capital and labour increase.

(ii) Law of Diminishing Costs:

The law can also be explained in term of diminishing costs. According to the law of diminishing costs as the output increases, average cost per unit goes on diminishing.

This fact is clear from table 5 and Figure 5.

It is evident from table 5, that with the application of the first unit of labour and capital, average cost is Rs. 10. With the application of the next unit, average cost comes down to Rs. 8. With the application of third, fourth and fifth units, it has further fallen to Rs. 6.66, Rs. 5.71 and Rs. 5.00 respectively.

In diagram 5, units of labour are shown on OX- axis and average cost on OY-axis and capital DC curve represents diminishing average cost. It slopes downward. It signifies that as more and more units of labour are employed, average cost goes on diminishing. When first unit of labour is employed the average cost is Rs. 10. In case of 2, 3, 4, 5 units, average cost declines to 8, 6.6, 5.7 and 5 respectively.

Causes of Increasing Returns:

Law of increasing returns applies due to following reasons:

1. Indivisibility of Factors of Production: One of the Main Reasons which Give Rise to the Law of Increasing Returns is the Indivisibility of Lumpiness of Factors of Production.

For instance, it is not possible to break machinery into two parts, nor it is possible to pass it on to another man, nor it is possible to make an organizer to look after two firms just because there is not much work in the firm which has employed the organizer.

Perhaps the same is true for the building. When the output is undertaken, it is unthinkable that a good organizer will purchase that machinery which can meet the present needs of the market, but he will always establish or purchase that size of plant which has sufficient potential to increase the amount of the product.

It means there is always some idle capacity in factors of production which is deliberately kept by the organizers to expand its production. It is on account of this that an organizer or machinery or building or even labourer is lumpy or indivisible.

2. Division of Labour. Law of Increasing Returns Operate on Account of Division of Labour.

It is not possible for the employer to have more complex division of labour and advantageous combination of factors of production, when production is carried on small scale basis and labour intensive technique is adopted, i.e., emphasis is laid on the employment of more labour rather than capital.

However, when production is carried on large scale basis, it is possible for a firm to have more complex and better machinery, i.e., it is possible to have complex division of labour and advantageous combination of factors of production ; which brings down the cost of production. And, a fall in cost of production means the operation of law of the diminishing cost or the law of increasing returns.

Hence, it can be concluded that the law of increasing returns operates as a result of division of labour and specialisation.

3. Internal and External Economies: The law of Increasing Returns Operate on Account of Internal and External Economies Available in Large Scale Production.

Internal and external economies relate to production, marketing finance and organisation. These internal and external economies are helpful in reducing the cost of production and increasing the amount of production.

Hence, economies that are available in large scale production, i.e., internal and external economies are helpful for operation of the law of increasing returns.

Why the Law Operates In Industry:

According to Dr. Marshall, the law of increasing returns is generally applicable to manufacturing industries as these units are dominated by man.

Its main reasons are under-stated:

1. Economies of Large Scale:

Initially, as we employ more and more units of variable factors with fixed factors, productivity of both the factors increases. It is only on account of several external as well as internal economies in the form of innovations; marketing, publicity, management etc. accrue to the producer. Due to these economies total cost per unit falls while the total product increases at an increasing rate.

2. Elastic Supply:

Generally, in the manufacturing industry, factors of production have elastic supply. It means demand of each factor can be increased whenever required. As we know, in the industrial sector, labour capital, and management play a pioneer role because these factors are elastic in supply which leads to the operation of this very law.

3. Division of Labour:

In the manufacturing industry, there is a wider scope for the division of labour. It means production can be divided and subdivided in a number of processes. Due to this advantage production is more than the proportionate increase in factors. Therefore, cost per unit goes on decreasing.

4. More Use of Machinery:

Another reason for the operation of this very law in the manufacturing industry is that there is more use of machinery than in the agricultural sector. The use of machinery reduces the cost per unit.

5. Innovation:

In the manufacturing industry, new inventions also play a positive role for the operation of the Law of Increasing Returns.

6. Less Impact of Nature:

In manufacturing sector, the nature is not as strong as it is in agriculture sector. Rain, winter and summer have no effect on industries.

7. Man is Supreme:

Man by his technical knowledge and far sightedness has succeeded in deferring the operation of the law of diminishing returns for a long period. Thus man is supreme. He plays a vital role for using the factors of production in a more proper way.

Similarities and Dissimilarities between the Law of Diminishing and Increasing Returns:

The Law of diminishing returns and increasing returns have similar as well dissimilar characteristics with each other.

Similarities:

1. Relationship of Input and Output:

The foremost similarity between the law of diminishing returns and increasing returns is that both laws establish relationship between input and output. They begin to operate as the efforts are made by the organizer to expand the production.

2. Single Tendency:

The law of increasing returns operate in the initial stage due to its idle capacity in the fixed factors of production while the law of diminishing returns operate in subsequent stage because that idle capacity is fully utilized. Therefore, both laws are said to be the two phases of a single tendency. Both laws show the change in cost of production when an effort is made to raise production.

Dissimilarities:

The main points of difference between the law of diminishing returns and increasing returns.

1. Better Study of Cost of Production:

The law of increasing returns makes better study regarding cost of production by establishing relationship between input and output. But in case of diminishing returns, it is not true because cost per unit increases with the increase in production. Thus, the producer has to decide at every stage whether he should increase the production or not.

2. Better Analysis of Price Effect:

The increasing return is the better analysis of price effect as the cost per unit falls when production increases. While the law of diminishing return is harmful because when cost of production increases, price also increases. Thus, increase in price which is the result of the law of diminishing returns has adverse effect on economic welfare.