How to use basic economic concepts in day-today life : #1

Applications of theoretical economic concepts in the real world 

(the law of increasing returns and the law of diminishing returns) 

Intro:  

Does the Law of Increasing Returns make sense? Does it have a real-world application? Yes, and yes! 

Hopefully, by the end of this article you will have some idea as to how the laws of increasing returns and decreasing returns work, but for now, a brief intro. These laws help companies make decisions on their expenditure. For example, a clothes manufacturing company can decide how many workers to hire so that it can maximise its profits. For these laws to work, we operate under the assumption that all other factors in the market remain constant (in simpler terms, stuff like the salary you pay each worker, the total number of machines the company has) 

These laws can be used by anyone and everyone and are often used in the real world, but we don’t actually see them. A manufacturing company can use these, but so can a pani-puri vendor! Many sellers of goods use these laws and everyone should. Making smart decisions is a plus no matter where you make them! 

1. 1.0 The Law of Increasing Returns 

The Law of Increasing Returns States that: “When more and more units of a variable factor is employed, while other factor remain fixed, there is an increase of production at a higher rate.” 

Basic definitions: Fixed factors refers to market conditions that will not be changing for the sake of calculations (for example, if I own a clothes manufacturing company, the space in the factory, the number of machines I have, the salary to pay each worker will be taken to be constant). A variable input would be the one thing I would be changing (in this scenario, the number of workers I hire). Increase in production at a higher rate simply means an increase in the rate of production. 

How I interpret this is that when we increase the variable factor, the rate of production will keep increasing. For example, the rate of production of shirts in my factory will keep increasing with the number of workers that I hire. Of course, this is only up till a certain point, and this will be explained later on in the article. 

1.1 Examples:  

1.1.a)

           Imagine a pani puri vendor ‘Aditya’. Aditya has certain fixed factors (already has certain things that he won’t be changing for the sake of this illustration like a food cart, a location to sell, etc.) What Aditya can change is the number of workers he hires. Now when Aditya is selling to a large crowd of hungry Mumbaikars who have a 10-minute lunch break or who need to catch the next metro, Aditya has to make these pani puris, and make them fast. However, Aditya has only 2 hands. He can either make the pani puris, or he can handle the transactions, but he can’t do both, without considerably reducing the efficiency of both actions. So, Aditya decides to hire a new worker Bharat. Aditya obviously has to pay Bharat a salary of say, ‘x’ rupees, but is incurring such a loss worth it? According to this Law, it certainly is! When Bharat starts working, Aditya can handle making the pani puris, while Bharat handles the transactions, effectively doubling their speed, hence the number of customers they can serve which effectively doubles their profits. So now with 4 hands on the job, the pani puri cart quickly earns back the initial investment (Bharat’s salary) as well as making more profits (or returns as they are called). So, as you can see, by increasing one factor (the number of workers) while keeping other factors constant (location of the food cart), there is a noticeable increase in the rate of production of the art, which leads to an increase in returns. This is the Law of Increasing Returns in effect! 

             

             1.1.b)         

                      Now, let's look at a farmer ‘Ram’. Ram has fixed factors too (for example the size of his plot of land, the crop he grows, etc.). Ram can change exactly one thing: the amount of fertiliser he uses. Previously, Ram could grow only so many crops on his field. With the invention of new farming tools like tractors and fertilisers, many farmers can grow more from less! Ram can’t afford to buy a tractor as he is a small farmer, but he can buy fertiliser; so, when he buys and uses fertiliser, the increase in the rate of production on his land increases by a lot! Again, this is the Law of Increasing Returns in action. (for the sake of illustration, imagine he produces 10 quintals of wheat the previous year and this year he produces 15 quintals of wheat with 1 bag of fertiliser, that’s a 50% increase in production. The next year when he uses 2 bags of fertiliser, he produces 25 quintals of wheat. That’s a 66% increase in production. Eventually if he keeps increasing the amount of fertiliser he uses, do you think the rate of production will keep increasing? Read on to find out.) 

2. 2.0 The Law of Diminishing Returns 

The Law of Decreasing Returns states that: “ if one factor of production (number of workers, for example) is increased while other factors (machines and workspace, for example) are held constant, the output per unit of the variable factor will eventually diminish.” 

Basic definitions: Similar definitions as before. Out-per-unit refers to the money I am making per unit investment (for example, how much more money I am making for each worker I hire) 

How I interpret this is, when we keep increasing the variable factor, eventually, the increase in the rate of production decreases. For example, from a 66% increase in the rate of production, the next year there is a 50% increase in the rate of production. Note that total production still increases, just that the rate of production  

      2.1. Example: 

1. 
   
2. 2.1.a) 
3.          Let’s look back at Aditya. After hiring Bharat, he realises that his profits have doubled. He thinks to himself “If I hire one more worker, will my profits triple?”. So, he hires a new worker Chaitanya. What happens is that the work of running the cart splits between the three people. So, each person now does a third of the work. Does that mean that the profits of the cart will triple? Well, not really. What happens is that while the cart gets a new set of hands, the steps involved can easily be handled by the other two. The total production of pani puris might increase, but the rate of production does not increase. So, this gets us thinking “How much is enough?”.  When Bharat joined the team, Aditya desperately needed a helping hand to cover all the tasks effectively. When this was taken care of, there was a significant increase in the rate of production. However, when he hired Chaitanya, there wasn’t a significant increase in the rate of production. Hence, despite the total production increasing, the rate of production actually decreased (for example’s sake, after Bharat joined, the increase in the rate of production was 100%, but after Chaitanya joined, it was 60%). This is the Law of Diminishing Returns. 

2. 2.1.b)
3.          Now, Let’s look back at Ram. Ram, like Aditya, sees the increase in returns from the added input and thinks of adding more. So, Ram buys more fertiliser and puts it on his field. He again sees an increase in his yield, but the increase is not as much as it was at first. But still, he keeps on adding fertiliser to his field. Eventually, his field is hyper-concentrated with fertilisers, which is actually damaging to his crops! (this is the worst-case scenario) Imagine that while the total amount of crops increases from 25 quintals to 35 quintals, despite a 10 quintal increase like the last time, the rate actually goes down to 40% as compared to 66%. This again is the Law of Diminishing Returns. 

3. Take-home message 

The answer to these questions can be found in the applications of these two laws. The Law of Increasing Returns applies up till a certain point after which the Law of Diminishing Returns runs its course. This point is known as “The Point of Maximum Returns”  

To better illustrate this point, here is another example. In my clothes manufacturing factory, I have 10 machines, each of which requires 1 person to handle it. While I keep hiring people to use each machine, my rate of production keeps increasing. But after I hire the 11th person, there isn’t a significant increase in the rate of production as the 11th person doesn’t have a machine to use, instead they help out a little in handling one of the other machines.  So the point of maximum returns for me would be hiring 10 employees. 

Using economic concepts like this helps everyone make smart decisions, whether they be a street side pani puri vendor or a large-scale manufacturer.

Sources:  

1. 1.https://www.toppr.com/guides/business-economics/theory-of-production-and-cost/the-law-of-diminishing-returns/ 
2. 2.https://economicsconcepts.com/law_of_increasing_returns.htm
3. 3.https://study.com/academy/lesson/law-of-diminishing-returns-definition-examples-quiz.html 
4. 4.http://www.businessdictionary.com/definition/law-of-diminishing-returns.html 
5. 5.http://www.economicsdiscussion.net/law-of-increasing-returns/law-of-increasing-returns-meaning-factors-responsible-and-limitations/13737 

6. 
   

Hari Shankaran