The law of returns to scale describes the relationship between outputs and scale of inputs in the long-run when all the inputs are increased in the same proportion. In the words of Prof. Roger Miller, “Returns to scale refer to the relationship between changes in output and proportionate changes in all factors of production. To meet a long-run change in demand, the firm increases its scale of production by using more space, more machines and labourers in the factory’.
(i) All factors (inputs) are variable but enterprise is fixed.
(ii) A worker works with given tools and implements.
(iii) Technological changes are absent.
(iv) There is perfect competition.
(v) The product is measured in quantities.
Given these assumptions, when all inputs are increased in unchanged proportions and the scale of production is expanded, the effect on output shows three stages: increasing returns to scale, constant returns to scale and diminishing returns to scale.
Increasing Returns to Scale
Returns to scale increase because the increase in total output is more than proportional to the increase in all inputs.
The table reveals that in the beginning with the scale of production of (1 worker + 2 acres of land), total output is 8. To increase output when the scale of production is doubled (2 workers + 4 acres of land), total returns are more than doubled. They become 17. Now if the scale is trebled (3 workers + о acres of land), returns become more than three-fold, i.e., 27. It shows increasing returns to scale. In the figure RS is the returns to scale curve where R to С portion indicates increasing returns.
Causes of Increasing Returns to Scale
Returns to scale increase due to the following reasons:
(i) Indivisibility of Factors
Returns to scale increase because of the indivisibility of the factors of production. Indivisibility means that machines, management, labour, finance, etc. cannot be available in very small sizes. They are available only in certain minimum sizes. When a business unit expands, the returns to scale increase because the indivisible factors are employed to their maximum capacity.
(ii) Specialization and Division of Labour
Increasing returns to scale also result from specialization and division of labour. When the scale of the firm is expanded there is wide scope of specialization and division of labour. Work can be divided into small tasks and workers can be concentrated to narrower range of processes. For this, specialised equipment can be installed. Thus with specialization, efficiency increases and increasing returns to scale follow.
(iii) Internal Economies
As the firm expands, it enjoys 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.
(iv) External Economies
A firm also enjoys increasing returns to scale due to 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.
2. Constant Returns to Scale
Returns to scale become constant as the increase in total output is in exact proportion to the increase in inputs. If the scale of production in increased further, total returns will increase in such a way that the marginal returns become constant. In the table, for the 4th and 5th units of the scale of production, marginal returns are 11, i.e., returns to scale are constant. In the figure, the portion from С to D of the RS curve is horizontal which depicts constant returns to scale. It means that increments of each input are constant at all levels of output.
Causes of Constant Returns to Scale
Returns to scale are constant due to:
(i) Internal Economies and Diseconomies: But increasing returns to scale do not continue indefinitely. As the firm expands further, internal economies are counterbalanced by internal diseconomies. Returns increase in the same proportion so that there are constant returns to scale over a large range of output.
(ii) External Economies and Diseconomies: The returns to scale are constant when external diseconomies and economies are neutralised and output increases in the same proportion.
(iii) Divisible Factors: When factors of production are perfectly divisible, substitutable, and homogeneous with perfectly elastic supplies at given prices, returns to scale are constant.
Diminishing Returns to Scale
Returns to scale diminish because the increase in output is less than proportional to the increase in inputs. The table shows that when output is increased from the 6th, 7th and 8th units, the total returns increase at a lower rate than before so that the marginal returns start diminishing successively to 10, 9 and 8. In the figure, the portion from D to S of the RS curve shows diminishing returns.
Causes of Diminishing Returns to Scale
Constant returns to scale is only a passing phase, for ultimately returns to scale start diminishing. Indivisible factors may become inefficient and less productive. 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. 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.
For the management increasing, decreasing or constant returns to scale reflect changes in production efficiency that result from scaling up productive inputs. But returns to scale is strictly a production and cost concept. Management’s decision on what to produce and how much to produce must be based upon the demand for the product. Therefore, demand and other factors must also be considered in decision making.