The Laws of Returns to Scale

The laws of returns to scale can also be explained in terms of the isoquant approach. The laws of returns to scale refer to the effects of a change in the scale of factors (inputs) upon output in the long-run when the combinations of factors are changed in some proportion.

The returns to scale can be shown diagrammatically on an expansion path “by the distance between successive ‘multiple-level-of-output’ isoquants, that is, isoquants that show levels of output which are multiples of some base level of output, e.g., 100, 200, 300, etc.”

Increasing Returns to Scale:

Figure 24.11 shows the case of increasing returns to scale where to get equal increases in output, lesser proportionate increases in both factors, labour and capital, are required.

It follows that in the figure:

100 units of output require 3C +3L

200 units of output require 5C + 5L

300 units of output require 6C + 6L

So that along the expansion path OR, OA > AB > BC.

Causes of increasing returns to scale

  1. Indivisibilities in machines, management, labour, finance, etc: Some items of equipment or some activities have a minimum size and cannot be divided into smaller units. When a business unit expands, the returns to scale increase because the indivisible factors are employed to their full capacity.
  2. Specialisation and division of labour: When the scale of the firm expands there is wide scope for specialisation and division of labour. Work can be divided into small tasks and workers can be concentrated to narrower range of processes. For this, specialized equipment can be installed. Thus with specialization, efficiency increases and increasing returns to scale follow.
  3. Internal economies of production: It may be able to install better machines, sell its products more easily, borrow money cheaply, procure the services of more efficient manager and workers, etc. All these economies help in increasing the returns to scale more than proportionately.
  4. External economies: When the industry itself expands to meet the increased ‘long-run demand for its product, external economies appear which are shared by all the firms in the industry. When a large number of firms are concentrated at one place, skilled labour, credit and transport facilities are easily available. Subsidiary industries crop up to help the main industry. Trade journals, research and training centres appear which help in increasing the productive efficiency of the firms. Thus these external economies are also the cause of increasing returns to scale.

Decreasing Returns to Scale:

Figure 24.12 shows the case of decreasing returns where to get equal increases in output, larger proportionate increases in both labour and capital are required.

It follows that:

100 units of output require 2C + 2L

200 units of output require 5C + 5L

300 units of output require 9C + 9L

So that along the expansion path OR, OG < GH < HK.

Causes of decreasing returns to scale : All these factors tend to raise costs and the expansion of the firms leads to diminishing returns to scale so that doubling the scale would not lead to doubling the output.

  1. Indivisible factors may become inefficient and less productive.
  2. Internal and External diseconomies. Business may become unwieldy and produce problems of supervision and coordination. Large management creates difficulties of control and rigidities. To these internal diseconomies are added external diseconomies of scale. These arise from higher factor prices or from diminishing productivities of the factors. As the industry continues to expand the demand for skilled labour, land, capital, etc. rises. There being perfect competition, intensive bidding raises wages, rent and interest. Prices of raw materials also go up. Transport and marketing difficulties emerge.
  3. Increase in business risk: Due to increase in inflation level, changes in the economy and many other factors can lead to the risk in the business that can reduce the efficiency of the businessman and employees and thus result in the decrease in efficiency of employees and then they will produce less and leads to dimishing return to scale.
  4. Lack of entrepreneurial efficiency: If the entrepreneur is not a good leader, motivator and coordinator then he wont be able to manage the things properly which will give rise to decreasing return to scale.
  5. Unhealthy management and organization
  6. Imperfect factor substitutability
  7. Transport bottlenecks and Marketing difficulties.

Constant Returns to Scale:

Figure 24.13 shows the case of constant returns to scale. Where the distance between the isoquants 100, 200 and 300 along the expansion path OR is the same, i.e., OD = DE = EF. It means that if units of both factors, labour and capital, are doubled, the output is doubled. To treble output, units of both factors are trebled.

It follows that:

100 units of output require 1 (2C + 2L) = 2C + 2L

200 units of output require 2(2C + 2L) = 4C + 4L

300 units of output require 3(2C + 2L) = 6C + 6L

Causes of constant returns to scale:

  1. The returns to scale are constant when internal economies enjoyed by a firm are neutralised by internal diseconomies so that output increases in the same proportion.
  2. Another reason is the balancing of external economies and external diseconomies. Constant returns to scale also result when factors of production are perfectly divisible, substitutable, homogeneous and their supplies are perfectly elastic at given prices.

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By Hassham

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