Returns to Scale: Meaning and Types | Production Function | Microeconomics

In this article we will discuss about:- 1. Meaning of Returns to Scale 2. Types of Returns to Scale 3. Variation.

Meaning of Returns to Scale:

The changes in output on account of the change in the factors of production in the same proportion are called the returns to scale. In the long run all the factors of production are variable and even the scale of production can be changed according to the demand for various goods and services in the economy. The returns to scale are concerned with long run production function. They are studied with the help of iso-product curves and iso-cost curves.

Types of Returns to Scale:

Returns to scale are of three types as follows:

1. Increasing Returns to Scale:

When the change in output is more than in proportion to the equi-proportional change in all the factors of production, then the operating law is called the increasing returns to scale. Thus, the rate of increase in output is faster than the increase in factors of production.

The distance between various iso-product curves decreases on the expansion path or scale line then the increasing returns to scale will operate. It reveals that the increase in output in the same proportion requires less ratio of labour and capital. Thus, output increases more than in proportion to the units of factors of production employed under this law. It can be explained with the help of Diagram 9.

Capital and labour are shown on OY-axis and OX-axis respectively. IP, IP₁, IP₂ and IP₃ are different iso-product curves showing different levels of output, viz., 10 units, 20 units, 30 units and 40 units. The distance between successive iso-product curves diminishes as output is expanded by increasing the scale. The distance OE>EE₁>E₁E₂>E₂E₃ which reveals that for equal increase in output, firm has to employ less and less amount of labour and capital.

Causes of Operating the Law:

The increasing returns to scale operate on account of the following causes or reasons:

(i) Indivisibilities of Inputs:

There are some factors of production which are indivisible. Indivisibility means that they are available in a given shape or they cannot be divided into small pieces. Machine, managers, research, finance and marketing are such examples of individualities. With the increase in the scale of production the efficiency increases and the output increases more than in proportion to the change in inputs.

(ii) Division of Labour and Specialisation:

When the scale of production is increased the division of labour and specialisation is introduced. A process of production is divided into sub-processes and each process is completed by each group of workers and at the same time the specialist are appointed for different departments, viz., finance manager, marketing manager, personnel manager, purchasing manager and so on and so forth. Their services lead to increase in the production and the increasing returns to scale operates.

(iii) Dimensional Efficiency:

Increasing returns to scale is the result of operating dimensional efficiency in a business firm which is on account of the large size. The size increases the efficiency of all inputs and the increasing returns operates. Thus the investment in capital assets after a point will increase the output due to increased dimension of efficiency.

(iv) Economies of Large Scale:

When the scale of production is increased the internal and external economies of scale will operate and on account of it the increasing returns to scale will also operate.

Internal economies are on account of firm’s size and organisation while external economies are caused by the concentration and localisation of industries. All these economies lead to increase in output more than in proportion to the change in the ratio of two inputs.

2. Constant Returns to Scale:

When the output of a firm increases in the same proportion in which the change in inputs takes place the law is called constant returns to scale. The proportion of two inputs remains constant. When all iso-product curves showing the same level of output have the equal distance between them on the expansion path or scale line, the law operating is called constant returns to scale.

It is explained with the following diagram:

Capital and labour are shown on OY-axis and OX-axis respectively. IP, IP₁, IP₂ and IP₃ are different iso-product curves showing different levels of output, viz., 10 units, 20 units, 30 units and 40 units.

The distance between iso-product curves is indicated by E, E₁, E₂ and E₃. The distance on scale line (OP) are equal. OE = EE₁ = E₁E₂ = E₂E₃. The distance between all iso-product curves remains constant which reveal that the production increases in the same proportion in which inputs are changed.

Hence, it is constant returns to scale. This law operates at the point where neither the internal and external economies nor internal and external diseconomies are enjoyed by the firm during long period.

3. Diminishing Returns to Scale:

When proportionate change in output is less than the proportionate change in all the factors of production their (inputs) ratio being equal, the diminishing returns to scale will operate. The distance between various iso-product curves on the scale line increases because for getting the same level of output we have to employ more of all inputs.

It is explained with the help of the following diagram:

Labour and capital are employed on OX-axis an OY-axis. OP is the scale line on which E, E₁, E₂ and E₃ different iso-product curves are showing different levels of output. The distance between these curves are increasing on the scale line which show that we have to employ more of inputs and the resultant output is less than in proportion to the change in inputs. OE<EE₁<E₁E₂<E₂E₃ which show the diminishing returns to scale.

Causes of Operating the Law:

The diminishing returns to scale operate on account of the following reasons:

(i) Diseconomies of Large Scale:

When the scale of production is increased the internal and external diseconomies of scale operate. On account of these diseconomies the output increases less than in proportion to the change in the inputs and the diminishing returns to scale operates.

(ii) Delay in Decision-Making and Its Implementation:

With the size of scale of production the decisions are taken at different levels of management. Delay in decision-making and its implementation lead to increase in output less than in proportion to the change in all variable inputs. Pressure from top management, red-tapism and diseconomies of managerial skill lead to diminishing returns to scale.

(iii) Managerial Inefficiency:

With the increase in the size and scale of production in the long period the management becomes a complicated process. It results into managerial inefficiency leading to operation of diminishing returns to scale.

(iv) Industrial Unrest:

With the increase in the size and scale of production the number of workers increases. There will be political affiliation of trade unions leading to strikes, lockouts, go slow tactics, gheraos, etc. These labour problems are not easily solved by the management. It adversely affects the production of individual firms or industries and diminishing returns to scale operates.

(v) Entrepreneur not Variable:

Entrepreneur is one of the factors of production. He is neither variable nor divisible input. In practice he is fixed and indivisible input and on account of change in other variable inputs the ratio under the large scale leads to imbalances and the law of diminishing returns to scale operates.

(vi) Over-Exploitation of Scarce Inputs:

When the scale of production is increased and some of the scarce inputs are exploited to unlimited extent the increase in output is less in proportion to change in all inputs during long period and diminishing return to scale operates.

Variation in Returns to Scale:

We have explained the various phases or stages of returns to scale when the long run production function operates. It is revealed in practice that with the increase in the scale of production the firm gets the operation of increasing returns to scale and thereafter constant returns to scale and ultimately the diminishing returns to scale operates. These varying returns to scale or phases of returns to scale can be seen from Diagram 12.

The above diagram shows varying returns to scale, namely, increasing returns to scale, constant returns to scale and diminishing returns to scale. Capital and labour are shown on OY-axis and OX-axis respectively. IP to IP₉ are different iso-product curves showing different levels of output. E to E₈ are different points on the scale line (OP) showing the different distances among the product curves.

From OE to OE₂ the increasing returns to scale is operating while from E₃ to E₅ the constant returns to scale operates and the last phase of production is the diminishing returns to scale from E₆ to E₈ on the scale line.