RETURNS TO SCALE

The term returns to scale arises in the context of a firm's production function. It explains the behaviour of rate of increase in the output/production to the subsequent increase in the inputs i.e. the factors of production in the long run. In the long run all factors of production are variable and subject to change due to a given increase in size/scale. The laws of Returns to scale is a set of three inter-related and chronological laws (stages) Law of Increasing Returns to Scale Law of Constant Returns to Scale Law of Diminishing returns to Scale. If output increases by that same proportional change then there are constant returns to scale (CRS). If output increases by less than that proportional change, there are decreasing returns to scale (DRS). If output increases by more than that proportional change, there are increasing returns to scale (IRS).

Three Phases of the Law of Returns to Scale:

Depending on whether the proportionate change in output exceeds, equals or decrease in proportionate to the change in both the inputs, the production is classified as increasing returns to scale, constant returns to scale and decreasing returns to scale.

1. Increasing Returns to Scale Increasing returns to scale arises due to the following reasons. Dimensional economies, Economies flowing from indivisibility Economies of specialization Technical economies, Managerial economies, Marketing economies Alfred Marshall explains increasing returns in terms of increased efficiency of labour and capital in the improved organization with the expanding scale of output and employment of factor unit. It is referred to as the economy of organization in the earlier stages of production.

2. Constant Returns to Scale As a firm continues to expand, it gradually exhausts the economies, internal and external, which enabled the operation of increasing returns to scale. In this stage, the economies and dis-economies of scale are exactly in balance over a particular range of output. In the case of constant returns to scale increases in all the inputs cause proportionate increases in output.

3. Diminishing Returns to Scale When a business firm continues to expand even beyond the point of constant returns, stage comes when diminishing returns to scale set in. There are decreasing returns to scale when the percentage increase in output is less than the percentage increase in input. As the size of the firm expands, managerial efficiency decreases. Another factor responsible for diminishing returns to scale in the limitation of exhaustibility of the natural resources, for example, doubling of coal-mining plants may not double the coal output, because of limited availability of coal deposits or due to difficult accessibility to coal deposits.