MANAGERIAL ECONOMICS

Returns to Scale
Biplab Sarkar
Department of Management Studies
MANAGERIAL ECONOMICS

Returns to Scale

Biplab Sarkar
Department of Management Studies
MANAGERIAL ECONOMICS
Returns to Scale

• Returns to scale refers to the degree by which output

changes as a result of a given change in the quantity of all
inputs used in production.
• We have
• Constant returns to scale if output increases in the
same proportion as input.
• Increasing returns to scale if output increases by a
greater proportion than input.
• Decreasing returns to scale if output increases by a
smaller proportion than input.
MANAGERIAL ECONOMICS
Returns to Scale

Constant Returns to Increasing Returns Decreasing Returns

Scale to Scale to Scale
MANAGERIAL ECONOMICS
Returns to Scale

• Simple production function, assuming a two-factor model, is

given as
Qx = f (K, L)

• If now, L and K are changed by a factor of h, and Q consequently

changes by a factor of λ

λ Qx = f (hK, hL), this will result in

• Constant Returns to scale if λ =h

• Increasing Returns to scale if λ >h
• Decreasing returns to scale if λ <h
MANAGERIAL ECONOMICS
Assumptions

The law of returns to scale assumes that:

1) All factors (inputs) are variable but enterprise is fixed.

2) A worker works with given tools and implements.
3) Technological changes are absent.
4) There is perfect competition.
5) The product is measured in quantities.

Given these assumptions, when all inputs are increased in

unchanged proportions and the scale of production is
expanded, the effect on output shows three stages: constant
returns to scale, increasing returns to scale, and decreasing
returns to scale.
MANAGERIAL ECONOMICS
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.

• 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.
MANAGERIAL ECONOMICS
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.
MANAGERIAL ECONOMICS
Decreasing Returns to Scale

• 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.

Important factors that determine diminishing returns are
managerial inefficiency and technical constraints.
MANAGERIAL ECONOMICS
Cobb-Douglas Production Function

Taking two Factors Labour (L) and Capital (K) we can define the production
function as given by Cobb-Douglas through their empirical study as below

α+β >1

Y = total production (the real value of all goods produced in a year)

L = labor input (the total number of person-hours worked in a year)
K = capital input (the real value of all machinery, equipment, and buildings)
A = total factor productivity

α and β are the output elasticities of capital and labor, respectively. These
values are constants determined by available technology.

If α + β = 1, then we have constant returns to scale,

α + β > 1, then we have increasing returns to scale
α + β < 1, then we have decreasing returns to scale
THANK YOU

Biplab Sarkar
Department of Management Studies
biplabsarkar@pes.edu
+91 80 6666 3333 Extn 337