1

Unit 6: Returns to Scale- Economies and Diseconomies of scale

Returns to Scale

In the long run all inputs are variable. Retunes to scale refer to how much output
changes given a proportionate change in all inputs. (Scale refers increase in the
size of the production)

Increasing Returns to Scale

When proportionate increase in inputs brings about more than proportionate

increase in output then returns to scale are increasing.

For instance, 10% increase in inputs brings about more that 10% (say 50%)
increase in output, returns to scale are increasing.

Increasing Returns to Scale:

The isoquants move closer together as inputs are increased along the line:

Constant Returns to Scale

When proportionate increase in inputs brings about the same proportionate

increase in output then returns to scale are constant.
 2

• That is, when 10% increase in inputs brings about 10% in output, returns to
scale are constant.

Constant Returns to Scale :

The isoquants are equally spaced as output increases proportionally

Decreasing Returns to Scale

When proportionate increase in inputs brings about less than proportionate

increase in output then returns to scale are increasing

For instance, when 10% increase in inputs brings about less than 10% increase
in output, returns to scale are decreasing.

Decreasing Returns to Scale

The distance between the isoquants increases as inputs are increased along the
line:
 3

Returns to Scale

• Suppose we start with initial level of inputs and output.

• X 0=f ( L, K )

• We increase all inputs by the same proportiont . The new level of output is X ¿
X ¿ =f (tL , tK )

• The new level of output X ¿ can be expressed as function of t and the initial
level of output X 0 .
¿ ν
X =t X 0

The production function is called homogenous. If t cannot be factored out

production function is non-homogenous. The power of ν is called degree of
homogeneity of the function and is a measure of returns to scale.

If ν=1 , we have constant returns ¿ scale .

If ν>1 , we have increasing returns ¿ scale .

If ν<1 , we have decreasing returns ¿ scale .

 4

Economies and Diseconomies of Scale

• Economies of Scale: it refers to a situation in which output can be doubled

for less than a doubling of cost. ( LRAC falls as the quantity of output
increases.)

• Diseconomies of Scale : It refers to a situation in which doubling output

requires more than doubling of cost.( LRAC rises as the quantity of output
increases)

• Technical Economies: The main technical economies result from the

specialisation of the capital equipment (and the associated labour) which
becomes possible only at large scales of production, and from the
indivisibilities of capital equipment.

• Large firms apply techniques of management involving a high degree of

mechanisation, such as telephones, telex machines, television screens and
computers. These techniques save time in the decision-making process and
speed up the processing of information, as well as increasing its amount and
its accuracy.

• Labour Economies: Larger scale allows division of labour and specialisation

of the labour force with the result of an improvement of the skills and hence
of the productivity of the various types of labour.

• In a small plant a worker may be assigned three or four different jobs, while
in a large plant these jobs are assigned to different workers. This division of
labour is not profitable at small scales of output, because the skilled workers
would stay unemployed part of the time. Moreover, division of labour results
in saving in time usually lost in going from one in going from one type of
work to another

Financial Economies:
 5

• Large firms usually borrow money more cheaply than small firms. This is
because they usually have more valuable assets which can be used as security
(collateral), and are seen to be a lower risk, especially in comparison with new
businesses. In fact, many new businesses fail within their first few years
because of cash-flow inadequacies. For example, for having a bank overdraft
facility, a supermarket may be charged 2 or 3 % less than a small independent
retailer.

• Selling or Marketing Economies: Selling economies are associated with the

distribution of the product of a firm. Advertising expenses are the part of
marketing economies. The larger the output, smaller the advertising cost per
unit of output. With the increase in scale, advertising expenses per unit of
output falls.

• Large firms can enter exclusive agreements with distributors, offer them
incentives to increase the sale.

Firms need to change the style of their product quite frequently in order to meet
the demands of their customers and the competition of the rival firms. A change
in the model or style of the product often involves considerable expenses in
research and development and new equipment. The spreading of such overheads
is lower per unit if the scale of output is large.

• Selling or Marketing Economies: Selling economies are associated with the

distribution of the product of a firm. Advertising expenses are the part of
marketing economies. The larger the output, smaller the advertising cost per
unit of output. With the increase in scale, advertising expenses per unit of
output falls.

• Large firms can enter exclusive agreements with distributors, offer them
incentives to increase the sale.
 6

Firms need to change the style of their product quite frequently in order to meet
the demands of their customers and the competition of the rival firms. A
change in the model or style of the product often involves considerable
expenses in research and development and new equipment. The spreading of
such overheads is lower per unit if the scale of output is large.

Diseconomies of Scale

• When long-run average cost rises as output increases, there are said to be
diseconomies of scale. Diseconomies of scale arise because of the following
reasons:

• Managing a larger firm may become more complex and inefficient as the
number of tasks increases. Thus diseconomies of scale can arise because of
coordination problem.

• The advantages of buying in bulk may have disappeared once certain

quantities are reached. At some point, available supplies of key inputs may be
limited, pushing their costs up.