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Returns to Scale
In economics, returns to scale describe what happens to long-run returns as the
scale of production increases, when all input levels including physical capital
usage are variable (able to be set by the firm). The concept of returns to scale arises
in the context of a firm's production function. It explains the long-run linkage of
the rate of increase in output (production) relative to associated increases in the
inputs (factors of production).
In the long run, all factors of production are variable and subject to change in
response to a given increase in production scale. While economies of scale show
the effect of an increased output level on unit costs, returns to scale focus only on
the relation between input and output quantities.
There are Three Types of Returns to Scale
Returns to scale is the variation, or change, in productivity that is the outcome
from a proportionate increase of all the input. The three possible outcomes are:
Increasing Returns to Scale, Decreasing Returns to Scale, and Constant Returns to
Scale.

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 1. Increasing Returns to Scale
Increasing returns to scale or diminishing cost refers to a situation when all factors
of production are increased, output increases at a higher rate. It means if all inputs
are doubled, output will also increase at the faster rate than double. Hence, it is
said to be increasing returns to scale. This increase is due to many reasons like
division external economies of scale. Increasing returns to scale can be illustrated
with the help of a diagram as follows.

R
Returns
P1

X
Q Q1 Units of
An increasing return to scale occurs when the output increases by a larger
proportion than the increase in inputs during the production process.

For example, if input is increased by 3 times, but output increases by 3.75 times,
then the firm or economy has experienced an increasing returns to scale.

When increasing returns to scale occurs, it results in economies of scale. This is

owing to the fact that efficiency increases when organizations progress from small-
scale to large-scale production.

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 2. Decreasing Returns to Scale

A decreasing return to scale occurs when the proportion of output is less than the
desired increased input during the production process. For example, if input is
increased by 3 times, but output is reduced 2 times, the firm or economy has
experienced decreasing returns to scale.

Decreasing returns to scale occurs when increasing inputs leads to a proportionally

smaller increase in output. Output

Decreasing
19.6 Returns to
19
14
10

3 4 8 9 Units of
Labor/Capi
Example of Decreasing Returns to Scale
For example, if a car firm increases its variable inputs (capital, raw materials and
labour) by 50%, but the output of cars, increases by only 35%, then we say there
are decreasing returns to scale from increasing the quantity of inputs.

For instances, if a soap manufacturer doubles its total input but gets only a
40% increase in total output, then it can be said to have experienced decreasing
returns to scale.

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 3. Constant Returns to Scale

When an increase in inputs (capital and labour) cause the same proportional
increase in output.

Output
Constant
48
Returns to
+20%
40
+20%
24
+20%
20
+20%

10 12 20 24 Units of
Labor/Capi
Constant returns to scale occur when increasing the number of inputs leads to an
equivalent increase in the output.

Returns to scale occur in the long run when both labor and capital are available.

Another example of Constant returns to scale

Inputs
Capita %change in inputs Output %Change in Output
Labor
l
10 80 20 4000
20
12 96 20 4800

Constant Returns and Economies of Scale

If a firm has constant returns to scale – we are more likely to have minimal
economies or diseconomies of scale.

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However, even with constant returns to scale, a firm could still experience
economies of scale (lower average costs with increased output).

This is because:

 Bulk buying economies – buying bigger quantity of input may enable

lower cost of average purchase (due to bulk buying economies)
 Marketing/financial economies