Law of Returns To Scale

The law of returns to scale is concerned with the scale of production. The scale of production of a firm is determined by the amount of factors units.

In the long run all factors are variable. The firm therefore can expand its production by using more of all inputs. When there is increase in the quantity of all factors in the long period, keeping the factor proportion constant, there is increase in the scale of production.

The concept of returns to scale explains the behavior of output when changes are made in the scale of production.

Thus, the relationship between quantities of output and the scale of production in the long run when all inputs are increased in the same proportion, is called law of returns to scale.

When inputs are increased proportionately i.e., scale is increased, there are three possibilities

  • Total output may increase more than proportionately as the inputs,
  • Total output may increase at same proportion as the inputs
  • Total output may increase less than proportionately as the inputs

Thus it indicates that there are three possible cases of returns to scale:

  • Increasing returns to scale,
  • Constant returns to scale and
  • Decreasing returns to scale.

 (1) Increasing Returns to Scale: If the output of a firm increases more than in proportion to an equal percentage increase in all inputs, the production is said to exhibit increasing returns to scale.

For example, if the amount of inputs are doubled and the output increases by more than double, it is said to be an increasing returns to scale. When there is an increase in the scale of production, it leads to lower average cost per unit produced as the firm enjoys economies of scale.

(2) Constant Returns to Scale: When all inputs are increased by a certain percentage, the output increases by the same percentage, the production function is said to exhibit constant returns to scale.

For example, if a firm doubles inputs, it doubles output. In case, it triples output. The constant scale of production has no effect on average cost per unit produced.

(3) Diminishing Returns to Scale:

The term ‘diminishing’ returns to scale refers to scale where output increases in a smaller proportion than the increase in all inputs.

For example, if a firm increases inputs by 100% but the output decreases by less than 100%, the firm is said to exhibit decreasing returns to scale. In case of decreasing returns to scale, the firm faces diseconomies of scale. The firm’s scale of production leads to higher average cost per unit produced.

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By Hassham

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