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

Scale of Total Marginal

Unit
Production Returns Returns

4 (Stage I -
1 Labor + 2
1 4 Increasing
Acres of Land
Returns)

2 Labor + 4
2 10 6
Acres of Land

3 Labor + 6
3 18 8
Acres of Land

10 (Stage II -
4 Labor + 8
4 28 Constant
Acres of Land
Returns)

5 Labor + 10
5 38 10
Acres of Land
 Scale of Total Marginal
Unit
Production Returns Returns

6 Labor + 12
6 48 10
Acres of Land

8 (Stage III -
7 Labor + 14
7 56 Decreasing
Acres of Land
Returns)

8 Labor + 16
8 62 6
Acres of Land

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

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 1, 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 1, 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 1, 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.

Isoquant Curve and Returns to a Factor:

Returns to a factor refers to the behavior of output in response to changing application of one factor of production
while other factors remaining constant. As in the case of returns to scale, there are three different aspects of returns
to a factor, viz., increasing returns, constant returns and diminishing returns.

The returns to a factor can be explained using isoquant techniques. It is assumed that capital is a fixed input and
labour is a variable input.

Different Stages of Returns to a Factor:

The different returns to a factor can be explained as follows:
(i) Increasing Returns to a Factor:
It occurs when additional application of the variable factor i.e., labour increases total output at increasing rate. Fig.
17 explains the situation of increasing returns to a factor.

In Fig. 17 capital is taken constant at OR units. The line RP shows how larger quantities of labour can be employed
to expand production. It is called output path.

The isoquant curves for 100, 200, 300 and 400 units of output shows that output is increasing by a constant amount
by 100 units. These isoquants intersect the output path RP at point E, F, G and H.
We see here that the distance between successive isoquant curves is decreasing, that is, less and less labour is needed
for every additional 100 units of output. This means an increasing marginal product of labour. However, the distance
EF is greater than FG and FG is greater than GH i.e.

EF = FH = GH

This means that 100 units increase in output can be obtained by employing successively lesser increments of labour.
Let us suppose that EF is 20 units of labour and FG is 10 units of labour. Then from E to F the additional 100 units
of output are obtained by employing additional 20 units of labour. From F to G additional 100 units of output is
obtained by employing only 10 more units of labour. In short, the marginal product of labour increases when output
is expanded along the output path RP.

(ii) Diminishing Returns to a Factor. Diminishing returns to a factor is a situation when increasing application of the
variable factor increases total output only at the diminishing rate.

Fig. 18 illustrates the situation of diminishing rate. When capital is taken constant at OR and production is expanded
by adding more labour, the distance between successive Isoquants becomes increasingly greater, that is even more
and more labour is needed for every additional 100 units of output. This shows a diminishing marginal product of
labour. The distance EF is less than FG and FG is less than GH.

EF < FG < GH Thus, 100 units increase in output can be obtained only by employing successively greater
increments of labour. Between E to F additional 100 units of output is obtained by applying additional 10 units of
labour. Between F to G additional 100 units of output is obtained by applying additional 20 units of labour.
Therefore, the marginal product of labour diminishes when output is expanded along the output path RP.
(iii) Constant Returns to a Factor:
A constant return to a factor occurs when increasing application of the variable factor increases total output only at a
constant rate. Fig. 19, we see that when capital is taken constant at OR and production is increased by adding more
labour, the distance between isoquants remains constant, so that same amount of labour is needed for every
additional 100 units of output.

This means a constant marginal product (MP) of labour. In other words, 100 units increase in output can be obtained
by employing equal increment of labour. The distance between different iso-quants remains equal. It can be written
as;

EF = FG = GH

Difference between Returns to Scale and Returns to a Factor:

With the help of Isoquant diagram, we can draw the difference between returns to scale and returns to factor.
Returns to scale implies that output is increased as all the inputs are increased in the same proportion. However, Fig.
20 shows difference between returns to scale and returns a factor.
In Fig. 20 on OX-axis labour is measured and on OY-axis capital. We draw straight lines OA, OB and OC through
the origin. These lines or rays show that both labour and capital are increased to expand output. Moreover, since the
lines OA, OB and OC are straight lines passing through the origin, the ratio between labour and capital remains
same along each one of these lines.

Moving along a ray like OA means to increase production or scale always with the same ratio of inputs. For instance
the isoquants in Fig. 20 show constant returns to scale. The isoquants for 100, 200, 300 and 400 units of output
intersect the straight lines OA, OB and OC at equal distance.

Thus; it requires twice as much of both capital and labour to produce 200 units instead of 100 units; 50 percent
further more to produce 300 instead of 200 and so on. In other words the rays show the returns to scale which
implies that to increase output both the inputs should be increased in the same proportion.

Returns to a factor or change in proportion refers one input is held constant while production is expanded by
increasing the quantity of the other input. The horizontal straight line RP is drawn on the assumption that capital is
kept constant at OR and production expanded by adding more labour. The vertical straight line LM is drawn on the
assumption that labour is held constant at OL and output is expanded by adding more capital.

As we move along these lines the amount of one input varies while of the other remains constant. Thus proportion
between the two outputs undergoes a change. The returns to a factor can be explained either by RP line or LM line
depending whether capital is held constant or labour is held constant. With capital constant at R; the producer moves
from to E, from E to F to G.

Therefore, the successive difference between the isoquants is increasing (FG > EF). This means that 100 units of
additional output can be obtained by employing successively greater increments of labour. This means diminishing
marginal product of labour. This is the case of diminishing returns to a factor. In short, both the concepts of returns
to scale and returns to a factor (change in factor proportions) can be explained by using the technique of Isoquants.