The laws of returns to scale

Laws of returns to scale explain the physical relationship between input and output in the long run.  In other words, it explains the behavior of output when all inputs vary in the same proportion.

There are three stages of returns to scale.

1.  Increasing returns to scale- Output increases by a greater proportion than the increase in input.

2.  Constant returns to scale-Output increases in same proportion as increase in input.

3.  Diminishing returns to scale-Output increases in a lesser proportion than the increase in input.

The three stages can be understood with the help of the following table.

The laws of returns to scale  can be explained with the help of a diagram as follows.

In the above diagram, the scale of input is measured on the X-axis and the marginal product is measured on the Y axis.  From point I to R the Marginal product increases depicting the increasing returns to scale.  From R to C the marginal product remains constant which depicts the constant returns to scale and Segment CD shows that the marginal product diminishes depicting the diminshing returns to scale 

The law of increasing returns to scale is due to Economies of scale.  Economies of scale refer to the advantages of large scale production. It can be divided into:

1. Internal economies which arise within the firm as a result of increasing the scale of output of the firm.  It includes:

a)  Technical economies- large firms can afford research & buy sophisticated equipment.

b)  Managerial economies- Large firms employ specialist managers to improve efficiency.

c)  Financial economies-large firms are financially more stable and can raise finance easily.

d)  Risk bearing economies- As firms grow, more products spread the risk over more markets.

e) Marketing economies-Large firms can efficiently market the products.

2.  External economies are those economies which accrue to all the firms in an industry as the industry expands.  External economies include the following.

a)  Cheaper raw material and capital equipment

b) Technological external economies

c)  Development of skilled labour.

d)  Growth of ancillary industries.

e)  Better transportation and marketing facilities

f)  Development of information services

The Law of Diminishing returns to scale is due to dis-Economies of scale.

Internal dis-economies are due the following reasons.

a)  Lack of co-ordination

b)  Loose control

c)  Lack of proper communication

d)  Lack of identification

External dis-economies include the following.
1.  Excessive pressure on transport facilities

2.  Dis-economies of air pollution & water pollution.

3.  Shortage of funds.

4. Increasing risks and marketing problems.

5.  Rise in the price of factors of production.