Law of Returns to Scale

When both the inputs become variable, and the change in both the inputs affects the change in the output and, correspondingly, the size of the firm changes, then it is known as the law of returns to scale. It is a long-run phenomenon where the supply of both labour and capital is elastic.

When both labour and capital are increased proportionately or simultaneously, then there are possibly three ways in which output can be increased.

• Output may increase more than proportionately to an increase in inputs
• Output may increase proportionately to an increase in inputs
• Output may increase less than proportionately to an increase in inputs

Correspondingly, there are three types of returns to scale.

1). When Output increases more than proportionately to an increase in inputs, then it is known as increasing returns to scale. For example, if labour and capital both increase by 50% and correspondingly the output increases by more than 50%, then it is known as the increasing returns to scale. Consider Figure 1:

As has been shown in the above diagram, 10 units of output (depicted by IQ1) are produced using one unit of labour and capital, but when the labour and capital were doubled, i.e. to 2 units each, then the output (depicted by IQ2) increased more than double, i.e. to 25 units.

Similarly, when the labour and capital were again increased by one more unit, then the output (depicted by IQ3) was increased to 50 instead of 30 units.

Increasing returns of scale happen because of the economies of scale. Following are the different types of economies of scale which lead to increasing returns of scale in a production process:

● Technical and managerial indivisibility: Since it is difficult to divide any machine or technique in fractions, therefore there is always a minimum amount of employment, machine and technique which are required for the production and which are indivisible in nature. When these inputs are increased, then they increase the production exponentially and hence increasing returns to scale take place.

● Higher degree of specialization: When the labour is specialized for a particular production technique/ process, then its productivity increases, leading to an increase in the output per labour. This leads to increasing returns to scale.

● Dimensional relations: For example, when the size of a room (15’ × 10’ = 150 sq. ft.) is doubled to 30’ × 20’, the area of the room is more than doubled, i.e., 30’ × 20’ = 600 sq. ft. When the diameter of a pipe is doubled, the flow of water is more than doubled. Following this dimensional relationship, when the labour and capital are doubled, the output is more than doubled over some level of output.

2). When Output increases proportionately to an increase in inputs, then it is known as constant returns to scale. For example, if labour and capital both increase by 50% and correspondingly, the output also increases by 50%, then it is known as constant returns to scale. Consider Figure 2:

As has been shown in the above diagram, 10 units of output (depicted by IQ1) are produced using one unit of labour and capital, but when the labour and capital were doubled, i.e. to 2 units each, then the output (depicted by IQ2) also doubled, i.e. to 20 units. Similarly, when the labour and capital were again increased by one more unit, then the output (depicted by IQ3) was increased to 30.

The constant returns to scale happen because there is a limit on economies of scale. When economies of scale disappear, and diseconomies are yet to begin, the returns to scale become constant. The diseconomies arise mainly because of decreasing efficiency of management and scarcity of certain inputs. Moreover, constant returns of scale appear when the factors of production are perfectly homogeneous, like the Cobb- Douglas production function.

3). When Output increases less than proportionately to an increase in inputs, then it is known as decreasing returns to scale. For example, if labour and capital both increase by 50% and correspondingly the output increases by 30%, then it is known as decreasing returns to scale. Consider Figure 3:

As has been shown in the above diagram, 10 units of output (depicted by IQ1) are produced using one unit of labour and capital, but when the labour and capital were doubled, i.e. to 2 units each, then the output (depicted by IQ2) did not double, i.e. it increases to 18 units instead of 20 units and so on.

Decreasing returns to scale happens because of diseconomies of scale. Mainly, when there are managerial diseconomies and the size of the firm expands, managerial efficiency decreases, causing a decrease in the rate of increase in output.

Moreover, when the natural resources exhaust nature, then also decreasing returns of scale appear. For instance, if the coal mines are doubled, then it may be possible that the coal production would not be doubled; rather, it just increases by less than double because of the limitedness of the coal deposits or difficult accessibility to coal deposits.

Read also- Production Function and Returns to Scale

Read More- Microeconomics

1. Microeconomics: Definition, Meaning and Scope
2. Methods of Analysis in Economics
3. Problem of Choice & Production Possibility Curve
4. Concept of Market & Market Mechanism in Economics
5. Concept of Demand and Supply in Economics
6. Concept of Equilibrium & Dis-equilibrium in Economics
7. Cardinal Utility Theory: Concept, Assumptions, Equilibrium & Drawbacks
8. Ordinal Utility Theory: Meaning & Assumptions
9. Indifference Curve: Concept, Properties & Shapes
10. Budget Line: Concept & Explanation
11. Consumer Equilibrium: Ordinal Approach, Income & Price Consumption Curve
12. Applications of Indifference Curve
13. Measuring Effects of Income & Excise Taxes and Income & Excise Subsidies
14. Normal Goods: Income & Substitution Effects
15. Inferior Goods: Income & Substitution Effects
16. Giffen Paradox or Giffen Goods: Income & Substitution Effects
17. Concept of Elasticity: Demand & Supply
18. Demand Elasticity: Price Elasticity, Income Elasticity & Cross Elasticity
19. Determinants of Price Elasticity of Demand
20. Measuring Price Elasticity of Demand
21. Price Elasticity of Supply and Its Determinants
22. Revealed Preference Theory of Samuelson: Concept, Assumptions & Explanation
23. Hicks’s Revision of Demand Theory
24. Choice Involving Risk and Uncertainty
25. Inter Temporal Choice: Budget Constraint & Consumer Preferences
26. Theories in Demand Analysis
27. Elementary Theory of Price Determination: Demand, Supply & Equilibrium Price
28. Cobweb Model: Concept, Theorem and Lagged Adjustments in Interrelated Markets
29. Production Function: Concept, Assumptions & Law of Diminishing Return
30. Isoquant: Assumptions and Properties
31. Isoquant Map and Economic Region of Production
32. Elasticity of Technical Substitution
33. Law of Returns to Scale
34. Production Function and Returns to Scale
35. Euler’s Theorem and Product Exhaustion Theorem
36. Technical Progress (Production Function)
37. Multi-Product Firm and Production Possibility Curve
38. Concept of Production Function
39. Cobb Douglas Production Function
40. CES Production Function
41. VES Production Function
42. Translog Production Function
43. Concepts of Costs: Private, Social, Explicit, Implicit and Opportunity
44. Traditional Theory of Costs: Short Run
45. Traditional Theory of Costs: Long Run
46. Modern Theory Of Cost: Short-run and Long-run
47. Modern Theory Of Cost: Short Run
48. Modern Theory Of Cost: Long Run
49. Empirical Evidences on the Shape of Cost Curves
50. Derivation of Short-Run Average and Marginal Cost Curves From Total Cost Curves
51. Cost Curves In The Long-Run: LRAC and LRMC
52. Economies of Scope
53. The Learning Curve
54. Perfect Competition: Meaning and Assumptions
55. Perfect Competition: Pricing and Output Decisions
56. Perfect Competition: Demand Curve
57. Perfect Competition Equilibrium: Short Run and Long Run
58. Monopoly: Meaning, Characteristics and Equilibrium (Short-run & Long-run)
59. Multi-Plant Monopoly
60. Deadweight Loss in Monopoly
61. Welfare Aspects of Monopoly
62. Price Discrimination under Monopoly: Types, Degree and Equilibrium
63. Monopolistic Competition: Concept, Characteristics and Criticism
64. Excess Capacity: Concept and Explanation
65. Difference Between Perfect Competition and Monopolistic Competition
66. Oligopoly Market: Concept, Types and Characteristics
67. Difference Between Oligopoly Market and Monopolistic Market
68. Oligopoly: Collusive Models- Cartel & Price Leadership
69. Oligopoly: Non-Collusive Models- Cournot, Stackelberg, Bertrand, Sweezy or Kinked Demand Curve
70. Monopsony Market Structure
71. Bilateral Monopoly Market Structure
72. Workable Competition in Market: Meaning and Explanation
73. Baumol’s Sales Revenue Maximization Model
74. Williamson’s Model of Managerial Discretion
75. Robin Marris Model of Managerial Enterprise
76. Hall and Hitch Full Cost Pricing Theory
77. Andrew’s Full Cost Pricing Theory
78. Bain’s Model of Limit Pricing
79. Sylos Labini’s Model of Limit Pricing
80. Behavioural Theory of Cyert and March
81. Game Theory: Concept, Application, and Example
82. Prisoner’s Dilemma: Concept and Example