Returns to Scale

Returns to Scale

Returns to scale is the proportion by which output changes when all inputs are varied in the same proportion. It can only occur in the long run since that is when all inputs or production factors can be altered. There are cost implications from returns to scale as it shows how costs of the inputs can be absorbed by units of the output produced by the business. The following are the three types of returns to scale:

Decreasing returns to scale: This occurs when a percentage change in all inputs leads to a smaller percentage change in the output of the firm. It is decreasing returns to scale if, for example, a 10% increase in all inputs results in only 5% increase in output. The unit cost of production will rise as inputs rise faster than output.

Increasing returns to scale: Sometimes, an alteration of all inputs results in a greater change in output and cost per unit of output falls. Unit cost declines due to the availability of more units of output to absorb the input costs. A 20% jump in output following a 10% boost in all inputs is an example of increasing returns to scale.

Constant returns to scale: A change in all inputs results in an equivalent change in output. For instance, a firm’s output goes up by 10% owing to a 10% rise in all its inputs. Average cost or unit cost remains unchanged as inputs and output increase in the same proportion.


Figure 1: Long Run Average Cost Curve showing returns to scale



Table 1: An example of returns to scale

 

Inputs (Units)

Total Output (Units)

% Change in Inputs  

% Change in Output

Returns to Scale

Capital

Labour

A

100

50

1000

  

 

B

200

100

1500

100%

50%

Decreasing returns to scale

C

300

150

2400

50%

60%

Increasing returns to scale

D

360

180

2880

20%

20%

Constant returns to scale