Notes economics

Q3. State and explain the Law of Variable Proportion.

Answer:
The law is about the production function (relationship between input and output)
with one factor variable keeping quantity of other factor fixed i.e. by bringing about
the changes in proportion between variable factor and the fixed factor. This law is
very important in the economics and it is supported by empirical evidence
particularly in the agricultural sector. The law of a\variable proportion is stated by
various economists in the following manner:
By F.Benham: “As the proportion of one factor in a combination of factors is
increased after a point, first the marginal and then the average product of that factor
will diminish.”
By G.J. Stigler: “As equal increments one input are added, the inputs of other
productive services being held constant, beyond a certain point the resulting
increments of product will decrease i.e. the marginal product will diminish”.

Thus, it is observed that the law refers to three aspects:

Behavior of output
Quantity of one factor is increased keeping quantity of other factors fixed
Marginal product and average product eventually declines.

ASSUMPTIONS
1. The state of technology remains unchanged. If there is an any improvement in
technology, then marginal and average product may rise instead of diminishing.
2. Alteration or variation in various factor proportion is done by varying some inputs
i.e. some inputs must be kept fixed. This law does not apply when all factors are
varied.
3. The law is also based on the assumption that there is a possibility of varying the
proportions in which the various factors can be combined to produce a product. If
factors were used in fixed proportion then the increase in one factor would not lead
to any increase in the output that means the marginal product of a factor is zero.
There are three stages of law of variable proportion namely”
Stage of increasing returns where marginal productivity increases
Stage of decreasing returns where marginal productivity decreases
Stage of negative returns where marginal productivity becomes negative.

THREE STAES OF LAW OF VARIABLE PROPORTION

As shown in figure, X-axis is measured the quantity of the variable factor and on the
Y-axis are measured the total product, average product and the marginal product. As
the variable factor is increases, we can see its effect on the total, average and
marginal productivity of a product changes. The behavior of these total, average and
marginal products of the variable factor consequent on the increase in its amount
can be seen through three stages which are as follows;

Stage-I
Increasing returns:
In this stage, total product to a point increases at an increasing rate. In the fig. From
the origin to the point F, slope of the total TP is increasing. I.e. Upto point F total
product curve increases at an increasing rate. The point F where the total product
stops increasing at an increasing rate and starts increasing at a diminishing rate is
called as the point of inflexion where corresponding vertically to this point of inflexion
marginal productivity is maximum. Upto the point F marginal product MP rises. The
average product curve rises through out the first stage Upto the point S. It is notable
that the marginal product in this stage increases but in later part it starts declining
but remains greater than the average product so that the average product continues
to rise.

Stage-2
Stage of diminishing returns:
In this stage, the total product increases but at a stage both the marginal product
and the average product of the variable factor are diminishing but are positive. At
point M marginal product of the variable factor is zero, which is corresponding to the
highest point H of the total product curve TP.

Stage-3
Stage of negative returns:
In this stage, the total product declines and therefore the TP curve slopes downward.
As a result, marginal product of a variable factor is negative and the marginal
product curve MP goes below X-axis. Average product curve therefore declines. The
stage is called the stage of negative returns. Since the marginal product of the
variable factor is negative during this stage.

EXPLANATION OF THE VARIOUS STAGES:

Increasing returns: As more and more units of variable factors are added to constant
quantity of fixed quantity of fixed factor then fixed factor gets more intensively &
effectively utilized and production increases at a rapid rate.
The variable factor i.e. no. Of workers increase as a firm expands its product. A
worker contributes three pairs of whose per day to the firm’s output. The total
product reaches seven pairs of shoes per day when the second worker contributes to
the production. Fuller utilization of machine is possible due to the addition of a
variable factor. One worker cannot take full advantage of the capabilities of
machinery. When the second worker joint it is possible to use the full potential of the
machinery. More over increasing returns can also be attributed to the principle of
division of labor or specialization of work.

Diminishing returns: The peculiar features of this stage are that the marginal product
falls through out the stage and finally touches to zero. Corresponding vertically is the
point H, which is the highest point of the TP curve. Where stage two ends.

The third stage is set in by hiring 3rd worker who adds only 3 pairs of shoes per day
as compared to 4v pairs per day added by the 2nd worker. Total product increases
but the gain from third worker is not as great as gain from second worker. Once the
point is reached at which variable factor is sufficient to ensure full utilization of fixed
factor, then further increase in variable factor will cause MP as well as AP to fall
because fixed factor has not become inadequate relative to the quantity of variable
factors. In stage two-fixed factor is scarce as compared to variable factor. According
to Joe Robinson famous economist, the factors of production are imperfect
substitutes for on another, the stage of diminishing returns occurs. Fixed factor is
scarce and variable factor is in abundance. If some factors are available that are
perfect substitutes of fixed factor then fixed factor would not have remained scarce.
The paucity of fixed could have been made up by such perfect substitutes. If one of
the variable factors added to the fixed factor were perfect substitute deficiency of
fixed could have been made up but elasticity of substitute between factors is not
infinite, substitution is not possible and diminishing returns occur.

3. Negative returns: Under this stage, marginal product falls below “X” axis i.e.
negative because total product starts falling. In this example this is set in by hiring
6th worker. The total product falls from 13 pairs of shoes per week to 12 pairs of
shoes per week. The large number of variable factors impairs the efficiency of the
fixed factor. The excessive variable factor as compared to less fixed factor results in
a fall of total output. In such a situation, a reduction in the units of the variable
factor will increase the total output.

Q4. Define ‘Business Cycle’. Explain various phases of business cycle.

Answer
Definition of A Business or Trade Cycle
The term “trade cycle” in economies refers to the wave-like fluctuations in the
aggregate economic activity. Particularly in employment, output and income. In
other words, trade cycles are ups and downs in economic activity. A trade cycle is
defined in various ways by different economists. For instance, Mitchell defined trade
cycle as a fluctuation in aggregate economic activity. According to Heberler, ‘The
business cycle in the general sense may be defined as on alternation of periods of
prosperity and depression, of good and bad trade.’

Keynes, points out that ‘A trade cycle is composed of periods of good trade
characterized by rising prices and low unemployment percentages, altering with
periods of bad trade characterized by tolling prices and high unemployment
percentages.’ Keynes, thus, stresses two indices namely, prices and unemployment,
for measuring the upswing and downswing of the business cycles.

PHASES OF BUSINESS CYCLES

The ups and downs in the economy are reflected by the fluctuations in aggregate
economic magnitudes, such as. Production, investment, employment, prices, wages,
bank credits. etc. The upward and downward movements in these magnitudes show
different phases of a business cycle. Basically there are only two phases in a cycle,
viz., prosperity and depression. But considering the intermediate stages between
prosperity and depression, the various phases of trade cycle may be enumerated as
follows: -
1) Expansion
2) Peak
3) Recession
4) Trough
5) Recovery and expansion.

The five phases of a business cycle have been presented in the figure below.

The figure showing phases of Business Cycle

1) Prosperity Expansion and Peak

The prosperity phase is characterized by rise in the national output, rise in consumer
and capital expenditure rise in the level of employment. Inventories of both input
and output increase. Debtors find it more and more convenient to pay off their debts.
Bank advances grow rapidly even thought bank rate increases. There is general
expansion of credit. Idle funds find their way to productive investment since stock
prices increase due to increase in profitability and dividend. Purchasing power
continues to flow in and out of all kinds of economic activities. So long as the
conditions permit, the expansion continues, following the multiplier process.

In he later stages of prosperity, however inputs start falling short of their demand.
Additional workers are hard to find. Hence additional workers can be obtained by
bidding a wage rate higher than the prevailing rates. Labor market becomes seller’s
market. A similar situation appears also in other input markets. Consequently, input
prices increase rapidly leading to increase in cost at production. As a result. Prices
increase and overtake the increase in output and employment. Cost of living
increases at a rate relatively higher than the increase in household income. Hence
consumers, particularly the wage earners and fixed income class. Review their
consumption. Consumer’s resistance gets momentum. Actual demand stagnates or
even decreases. The first and most pronounced impact falls on the demand for new
houses, flats and apartments. Following this, demand for cement, iron and steel,
construction-labor tends to halt, this trend subsequently appears in other durable
goods industries like automobiles. refrigerators, furniture, etc. This marks reaching
the Peak.

2) Turning- Point and Recession

Once the economy reaches the peak, increase in demand is halted. It even starts
decreasing in some sectors, for the reason stated above. Producers, on the other
band, unaware of this fact continue to maintain their existing levels of production
and investment. As a result, a discrepancy between output supply and demand
arises. The growth of discrepancy. Between supply and demand is so slow that it
goes unnoticed for some time. But producers suddenly realize that their inventories
are piling up. This situation might appear in a few industries at the first instance. But
later it spreads to other industries also, initially, it might be taken as a problem
arisen out of minor maladjustment. But, the persistence of the problem makes the
producers believe that they have indulged in ‘over-investment’. Consequently, future
investment plans are given up; orders placed for new equipments, raw materials and
other inputs are cancelled. Replacement of worn-out capital is postponed. Demand
for labor ceases to increase; rather. Temporary and casual workers are removed in a
bid to bring demand and supply in balance. The cancellation of orders for the inputs
by the producers of consumer goods creates a chain -reaction in the input market,
Producers of capital goods and raw materials cancel their orders for their input. This
is the turning point and the beginning of recession.

Since demand for inputs has decreased, input prices. E.g. wages, interest etc. show
a gradual decline leading to a simultaneous decrease in the incomes of wage and
interest earners, This ultimately causes demand recession, Oil the other band,
producers lower down the price in order to get rid of their inventories and also to
meet their obligations. Consumers in their turn expect a further decrease in price
and hence postpone their purchases. As a result the discrepancy between demand
and supply continues to grow. When this process gathers speed, it takes the form of
irreversible recession. Investments start declining, the decline in investment leads to
decline in Income and consumption. The process of reverse of (of negative)
multiplier gets underway. (The process is exactly reverse of expansion). When
investments are curtailed, production and employment decline resulting in further
decline in demand for both consumer and capital goods. Borrowings for investment
decreases; bank credit shrinks: share prices decrease; unemployment gets
generated along with a fall in wage rates. At this stage, the process of recession is
complete and the economy enters the phase of depression.

3) Depression and Trough

During the phase of depression, economic activities slide down their normal level,
the growth rate becomes negative. The level of national income and expenditure
declines rapidly. Prices of consumer and capital goods decline steadily. Workers lose
their jobs. Debtors find it difficult to pay off their debts. Demand for bank credit
reaches its low ebb and banks experience mounting of their cash balances.
Investment in stock becomes less profitable and least attractive. At the depth of
depression, all economic activities touch the bottom and the phase of trough is
reached. Even the expenditure on maintenance is deferred in view of excess
production capacity. Weaker firms are eliminated form the industries. At this point
the process of depression is complete.

How is the process reversed? The factors reverse the downswing varies from cycle to
cycle like factors responsible for business cycle vary form cycle to cycle. Generally,
the process begins in the labor market. Because of widespread unemployment:
workers offer to work at wages less than the prevailing rates. The producers
anticipating better future try to maintain their capital stock and offer jobs to some
workers here and there. They do so also because they feel encouraged by the halt in
decrease in price in the trough phase. Consumers on their part expecting no further
decline in price begin to spend on there postponed consumption and hence demand
picks up, though gradually.

Besides, there is a self - correcting process within the price mechanism. When prices
fall during recession the prices of raw materials and that of other inputs fall faster
than the prices of finished products. Therefore, some profitability always remains
there, which tends to increase after the trough. Hence the optimism generated in the
stock market gets strengthened in the commodity market. Producers start replacing
the worn - out capital and making - up the depleted capital stock, though cautiously
and slowly. Consequently. Investment picks up and employment gradually increases,
following this recovery in production and income, demand for both consumer and
capital goods start increasing. Since banks have accumulated excess cash reserves,
bank credit becomes easily available and at a lower rate. Speculative increase in
prices gives indication of continued rise in levee. For all these reason the economic
activities get accelerated. Due to increase in income and consumption. The process
of multiplier gives further impetus to the economic activities, and the phase of
recovery gets underway. The phase of depression comes to an end over time
depending on the speed of recovery.

4) The Recovery
As the recovery gathers momentum, some firms plan additional investment, some
undertake renovation programmes, some undertake both. These activities generate
construction activities in both consumer and capital good sectors. Individuals who
had postponed their plans to construct houses undertake it now, lest cost of
construction mounts up. As a result, more and more reemployment is generated in
the construction sector, as employment increases despite wage rates moving upward
the total wage income increase at a rate higher than employment rate. Wage income
rises, so does the consumption expenditure. Businessmen realize quick turn over and
an increase in profitability. Hence, they speed up the production machinery.

Over a period, as the factors of production become more fully employed wages and
other input prices move upward rapidly. Investors therefore, become discriminatory
between alternative investments. As prices, wages and other factor - prices increase,
a number of related developments begin to take place. Businessmen start increasing
their inventories, consumers start buying more and more of durable goods and
variety items. With this process catching up. The economy enters the phase of
expansion and prosperity. The cycle is thus complete.