Laws of Returns to Scale and Its Types
Increasing, Constant and Decreasing Returns to Scale
Micro Economics Notes
Laws of Returns to Scale
It is a Long run concept. All factors of production are variable in the long period. No factor is a fixed factor. Accordingly, scale of production can be changed by changing the quantity of all factors.
According to Koutsiyannis “The term returns to scale refers to the changes in output as all factors change by the same proportion.”
Types of Laws of Returns
There are three aspects to Laws of Return to Scale:
1. Increasing Return to Scale.
2. Constant Returns to Scale.
3. Decreasing Returns to Scale.
1. Increasing Returns to Scale
When inputs are increased in a given proportion and output increases in a greater proportion, the returns to scale are said to be increasing.
In other words, proportionate increase in all factors of production results in a more than proportionate increase in output It is a case of increasing returns to scale. Thus, if by 100 percent increase in factors of production, output increases by 120 percent or more, it will be an instance of increasing returns to scale.
If the industry is enjoying increasing returns, then its marginal product increases. As the output expands, marginal costs come down. The price of the product also comes down.
Causes of Increasing Returns:
a) It is said that scarcity of an essential factor is responsible for the operation of Law of Diminishing Returns. On the other hand, if the factors of production are available in required quantities for increasing output the Law of Increasing Returns will operate in the industry.
b) Increasing Returns also arise when defective combination of factors is set right. Suppose the combination of factors is defective. As we increase the factors to save the combination a right one, the marginal returns will increase till the right combination is achieved.
c) It is stated that an increase in the capital and labour improves the organization and, as a result, efficiency of factors is increased. Increased efficiency of factors leads to larger output and lower cost of production.
d) Increase returns occur mainly because most of the factors cannot be divided into smaller units. In other words, most of the factors are indivisible.
Suppose a cement factory has a plant with a capacity to produce 500 tons a day. Whether we want to produce 100 tons, 200 or 500 tons, we must use the entire plant. The plant cannot be divided. In other words, it is indivisible. Suppose the firm is actually producing only 100 tons a day. In this case the plant is not utilized to the fullest extent. But the overhead or fixed costs like rent, insurance, interest on loans, salaries and wages of permanent employees etc., remain the same, whether the output is small or large. Suppose the fixed costs per day are Rs. 10,000. When the output is 50 tons, the fixed cost per ton is Rs. 200. When the output 100 tons the average fixed cot falls to Rs. 100. If output increases to 500 tons the fixed cost falls to Rs. 20. Thus the average cost of production continues to fall till the output reached 500 tons, assuming that other factors like labour and raw material can be secured at constant prices. Even if the price other factors are increasing, increasing returns can the secured until the rise in the price of other factors is more than the reduction in the fixed cost per unit.
e) Increasing returns also arise because of increased specialization. As more capital and labour are applied, the producer can introduce better division of labour, use costly and up-to-date machines and use specialized machinery. He can secure the services of experts and he can assign each one of them work for which he is best fitted; He can employ highly skilled labour even at high wages. As a result, cost of production falls. Falling cost may also arise when industry grows is size. Every firm derives certain economies or advantages as the industry growing size.
But it should be noted that increasing returns cannot be secured indefinitely. The average cost will continue to fall till a stage is reached when the factors are combined in the right proportion. At this stage, the factors are being used most efficiently and the average cost will be the lowest. The output at which the cost of production is the lowest is called the optimum output. If the output is increased beyond this stage average cost of production will rise. This is due to the fact that the indivisible factors like machines are now being used too fully. In other words, the factors are being worked too hard. The entrepreneur may not be able to manage most efficiently when the firm is expanded beyond the optimum beyond the optimum size. There will be too many workers per machine. In other words, the factors are combined in wrong proportions.
2. Constant Returns to Scale
When inputs are increased in a given proportion and output increases in the same proportion, constant return to scale is said to prevail. For example, if inputs are increased by 25% and output also increases by 25%, the return to scale are said to be constant (= 1). This may be called homogeneous production function of the first degree. In case of constant returns to scale the average output remains constant. Constant returns to scale operate when the economies of the large scale production balance with the diseconomies.
3. Decreasing Returns to Sale
Decreasing returns to scale is otherwise known as the law of diminishing returns. This is an important law of production. If the firm continues to expand beyond the stage of constant returns, the stage of diminishing returns to scale will start operating. A proportionate increase in all inputs results in less than proportionate increase in output, the returns to scale is said to be decreasing. For example, if inputs are increased by 20%, but output increases by only 10%, (= < 1), it is a case of decreasing return to scale. Decreasing return to scale implies increasing costs to scale.