Page 116 - DECO405_MANAGERIAL_ECONOMICS

Unit 7: Laws of Production

in the business. Apparently, investors also think so, for Arvind's stock price has been Notes
falling since Q4 1994 despite such excellent results and, at the end of the first quarter of
1998, is less than 70 compared to 170 at the end of 1994.
Unfortunately, Arvind's deteriorating financial returns over the last few years is also
typical of the Indian textile industry. The top three Indian companies actually showed a
decline in their return ratios in contrast to the international majors. Nike, VF Corp and
Coats Viyella showed a growth in their returns on capital employed of 6.2 per cent, while
the ROCE of Grasim and Coats Viyella (India) fell by almost 2 per cent per annum. Even
in absolute returns on assets or on capital employed, Indian companies fare a lot worse.
While Indian textile companies just about cover their WACC, their international rivals
earn about 8 per cent in excess of their cost of capital.
Questions
1. Is Indian companies running a risk by not giving attention to cost cutting?
2. Discuss whether Indian Consumer goods industry is growing at the cost of future
profitability.
3. Discuss capital and labour productivity in engineering context and pharmaceutical
industries in India.
4. Is textile industry in India performing better than its global competitors?

7.2 Returns to Scale (Law of Returns to Scale)

If all inputs are changed at the same time (possible only in the long run), and suppose are
increased proportionately, then the concept of returns to scale has to be used to understand the
behaviour of output. The behaviour of output is studied when all factors of production are
changed in the same direction and proportion.
In the long run, output can be increased by increasing the ‘scale of operations’. When we speak
of increasing the ‘scale of operations’ we mean increasing all the factors at the same time and by
the same proportion. For example, in a factory, in the long run, the scale of operations may be
increased by doubling the inputs of labour and capital. The laws that govern the scale of operation
are called the laws of returns of scale.
The laws of returns to scale always refer to the long run because only in the long run are all the
factors of production variable. In other words, only in the long run is it possible to change all the
factors of production. Thus the laws of returns to scale refer to that time in the future when
changes in output are brought about by increasing all inputs at the same time and in same
proportion.
Returns to scale are classified as follows:
1. Increasing Returns to Scale (IRS): If output increases more than proportionate to the
increase in all inputs.
2. Constant Returns to Scale (CRS): If all inputs are increased by some proportion, output
will also increase by the same proportion.

3. Decreasing Returns to Scale (DRS): If increase in output is less than proportionate to the
increase in all inputs.
For example, if all factors of production are doubled and output increases by more than two
times, then the situation is of increasing returns to scale. On the other hand, if output does not
double even after a cent per cent increase in input factors, we have diminishing returns to scale.

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