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Law of Returns to Scale

In the long- run the dichotomy between fixed factor and variable factor ceases. In other words, in the long-run all factors are variable. The law of returns to scale examines the relationship between output and the scale of inputs in the long-run when all the inputs are increased in the same proportion.

Assumptions

This law is based on the following assumptions:

  1. All the factors of production (such as land, labor and capital) but organization are variable
  2. The law assumes constant technological state. It means that there is no change in technology during the time considered.
  3. The market is perfectly competitive.
  4. Outputs or returns are measured in physical terms.

Three phases of returns to scale

There are three phases of returns in the long-run which may be separately described as

(1) the law of increasing returns

(2) the law of constant returns and

(3) the law of decreasing returns.

Depending on whether the proportionate change in output equals, exceeds, or falls short of the proportionate change in both the inputs, a production function is classified as showing constant, increasing or decreasing returns to scale.

Let us take a numerical example to explain the behavior of the law of returns to scale.

Table 1: Returns to Scale

Unit
Scale of Production
Total Returns
Marginal Returns
1
1 Labor + 2 Acres of Land
4
4 (Stage I – Increasing Returns)
2
2 Labor + 4 Acres of Land
10
6
3
3 Labor + 6 Acres of Land
18
8
4
4 Labor + 8 Acres of Land
28
10 (Stage II – Constant Returns)
5
5 Labor + 10 Acres of Land
38
10
6
6 Labor + 12 Acres of Land
48
10
7
7 Labor + 14 Acres of Land
56
8 (Stage III – Decreasing Returns)
8
8 Labor + 16 Acres of Land
62
6

The data of table 1 can be represented in the form of figure 

RS = Returns to scale curve

RP = Segment; increasing returns to scale

PQ = segment; constant returns to scale

QS = segment; decreasing returns to scale

Increasing Returns to Scale

In figure , stage I represents increasing returns to scale. During this stage, the firm enjoys various internal and external economies such as dimensional economies, economies flowing from indivisibility, economies of specialization, technical economies, managerial economies and marketing economies. Economies simply mean advantages for the firm. Due to these economies, the firm realizes increasing returns to scale. Marshall explains increasing returns in terms of “increased efficiency” of labor and capital in the improved organization with the expanding scale of output and employment factor unit. It is referred to as the economy of organization in the earlier stages of production.

Constant Returns to Scale

In figure , the stage II represents constant returns to scale. During this stage, the economies accrued during the first stage start vanishing and diseconomies arise. Diseconomies refers to the limiting factors for the firm’s expansion. Emergence of diseconomies is a natural process when a firm expands beyond certain stage. In the stage II, the economies and diseconomies of scale are exactly in balance over a particular range of output. When a firm is at constant returns to scale, an increase in all inputs leads to a proportionate increase in output but to an extent.

A production function showing constant returns to scale is often called ‘linear and homogeneous’ or ‘homogeneous of the first degree.’ For example, the Cobb-Douglas production function is a linear and homogeneous production function.

Diminishing Returns to Scale

In figure , the stage III represents diminishing returns or decreasing returns. This situation arises when a firm expands its operation even after the point of constant returns. Decreasing returns mean that increase in the total output is not proportionate according to the increase in the input. Because of this, the marginal output starts decreasing (see table 1). Important factors that determine diminishing returns are managerial inefficiency and technical constraints.

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