Law of Returns to Scale: Meaning and Stages

What is the Law of Returns to Scale?

Returns to scale refer to the change in output that results from a change in the factor inputs simultaneously in the same proportion in the long run. Simply put, when a firm changes the quantity of all inputs in the long run, it changes the scale of production for the goods. 

According to Watson, “Returns to Scale is related to the behaviour of total output as all inputs are varied in same proportion and it is a long run concept.”

Three Stages of Returns to Scale

According to the Law of Returns to Scale, when all the factor inputs are varied in the same proportions, then the scale of production may take three forms; viz., Increasing Returns to Scale, Constant Return to Scale, and Diminishing Returns to Scale.

1. Increasing Returns to Scale:

In the first stage of Returns to Scale, the proportionate increase in total output is more than the proportionate increase in inputs. In simple terms, if all the inputs increase by 100%, then the increase in output will be more than 100%.

Example:

Inputs (Units) (K = Capital, L = Labour)	Output (Units)	Percentage Increase in Inputs	Percentage Increase in Outputs
2K + 4L	200	–	–
4K + 8L	450	100%	160%
6K + 12L	600	100%	120%

The main reason behind Increasing Returns to Scale is Economies of Large Scale. Economies mean the benefits because of the large scale of production. Economies of scale are of two types; viz., Internal Economies and External Economies.

• Internal Economies: Internal Economies means the benefits of large-scale production available to an organisation within its own operation.  For example, Managerial Economies are achieved by dividing labour and specialisation.
• External Economies: External Economies mean the benefits of large-scale production shared by all the firms of an industry when the industry as a whole expands. For example, better infrastructural facilities, better transportation, etc.

2. Constant Return to Scale:

In the second stage of Returns to Scale, the proportionate increase in the total output is equal to the proportionate increase in inputs. In simple terms, if all the inputs increase by 100%, then the increase in output will also be 100%.

Example:

Inputs (Units) (K = Capital, L = Labour)	Output (Units)	Percentage Increase in Inputs	Percentage Increase in Outputs
6K + 12L	600	–	–
8K + 16L	1,000	100%	100%
10K + 20L	2,300	100%	100%

Once the firm has achieved the point of optimum capacity, it operates on Constant Returns to Scale. After the point of optimum capacity, the economies of production are counterbalanced by the diseconomies of production.

3. Diminishing Returns to Scale:

In the third stage of Returns to Scale, the proportionate increase in the total output is less than the proportionate increase in inputs. In simple terms, if all the inputs increase by 100%, then the increase in output will be less than 100%.

Example:

Inputs (Units) (K = Capital, L = Labour)	Output (Units)	Percentage Increase in Inputs	Percentage Increase in Outputs
10K + 20L	2,300	–	–
12K + 24L	4,600	100%	80%
14K + 28L	6,000	100%	75%

The main reason behind Diminishing Returns to Scale is Diseconomies of Large Scale. Diseconomies of Scale mean that the firm has now become so large that it has become difficult to manage its operations. Diseconomies of Scale are of two types; viz., Internal Diseconomies and External Diseconomies.

• Internal Diseconomies: Internal Diseconomies means the disadvantages of the large-scale production that a firm has to suffer because of its own operations. For example, Technological Diseconomies because of the heavy cost of wear and tear.
• External Diseconomies: External Diseconomies mean the disadvantages of large-scale production that all the firms of the industry have to suffer when the industry as a whole expands. For example, stiff competition, etc.