The distinction between the two types of factors is the basis of cost analysis and the law of returns. If all the factors of production were perfectly divisible and variable, the cost of production would have increased in the exact proportion of the output. As this is not the case, a special cost analysis becomes important. The classification of costs can be summarized as follows:

(B) Total and Marginal Output: In the act of production, a progressive increase in the input results in a similar increase in the output. There is a significant difference in the composition of input and its effect on the output. In the short run, the total employment of fixed factors of production remains constant as regards quantity and quality. Fixed inputs are lumpy in the sense they are to be employed in a single big unit that may be available. Let us assume that machines, factory premises and the manager together make up for a lumpy unit of fixed factors. So long as variable factors are not employed no output can be produced. Since variable factors are divisible into small units, they can be employed and increased in small doses. Let us assume one worker and a small quantity of raw materials together form a variable input unit. With every increase in the variable unit, output will increase simultaneously. This increase will appear in the total output. Such an increase in the total output is not exactly proportional. Every additional variable unit may make a different contribution to the firm’s total output. Such additions, of individual variable units, are called the marginal product. It is important to note that the marginal product is essentially an outcome of the functioning of variable input units. This is because fixed inputs are not themselves capable of producing any output. In this sense fixed inputs are ’supplementary’ while variable units are ’prime’ in their contributions. This can be illustrated with the help of a numerical example. The entire process of productive activity in the example is subject to the law of variable returns.

(C) Production Function and the Law of Returns: The relation between input and output is called the production function:

Q = f (L, K)

It states that the output produced (Q) is functionally dependent on the units of input: labor (L) and capital (K). Though in the simplified form of the function, only two inputs have been shown, the relation can be extended to a range of input quantities and qualities. Labor (L) in general symbolizes all types of human services utilized in productive activity. Similarly capital (K) symbolizes different types of material or physical agents of production.