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.
This law of returns to scale in economics is based on the following assumptions;
- All factors are variable but the enterprise is fixed.
- There is no change in technology.
- Perfect competition prevails in the market.
- Returns are measured in physical terms.
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 increasing returns in terms of “increased efficiency” of labor 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 exhaust 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.
A production function showing constant returns to scale is often called ‘Linear and Homogeneous’ or ‘Homogeneous of the first Degree’. The Cobb-Douglas production function evolved by the American economists Cobb and Douglas is a linear and homogeneous production function.
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.