Law of returns to scale

Law of Returns to Scale
In the long run all factors of production are
variable. No factor is fixed. Accordingly, the
scale of production can be changed by
changing the quantity of all factors of
production.

Definition
• “The term returns to scale refers to the
changes in output as all factors change by the
same proportion.” Koutsoyiannis
• “Returns to scale relates to the behaviour of
total output as all inputs are varied and is a
long run concept”.

Returns to scale are of the following
three types:
• 1. Increasing Returns to scale.
• 2. Constant Returns to Scale
• 3. Diminishing Returns to Scale

• Explanation:
• In the long run, output can be increased by
increasing all factors in the same proportion.
Generally, laws of returns to scale refer to an
increase in output due to increase in all factors
in the same proportion. Such an increase is
called returns to scale.
• Suppose, initially production function is as
follows:
• P = f (L, K)

Now, if both the factors of production i.e., labour and capital are increased in same
proportion i.e., x, product function will be rewritten as.

• 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 8.
•

In figure 8, OX axis represents increase in labour and capital
while OY axis shows increase in output. When labour and capital
increases from Q to Q1, output also increases from P to P1 which
is higher than the factors of production i.e. labour and capital.

Diminishing Returns to Scale:
Diminishing returns or increasing costs refer to
that production situation, where if all the factors
of production are increased in a given
proportion, output increases in a smaller
proportion. It means, if inputs are doubled,
output will be less than doubled. If 20 percent
increase in labour and capital is followed by 10
percent increase in output, then it is an instance
of diminishing returns to scale.

In this diagram 9, diminishing returns to scale has been shown.
On OX axis, labour and capital are given while on OY axis, output.
When factors of production increase from Q to Q1 (more
quantity) but as a result increase in output, i.e. P to P1 is less. We
see that increase in factors of production is more and increase in
production is comparatively less, thus diminishing returns to
scale apply.

Constant Returns to Scale:
• Constant returns to scale or constant cost refers to the
production situation in which output increases exactly
in the same proportion in which factors of production
are increased. In simple terms, if factors of production
are doubled output will also be doubled.
• In this case internal and external economies are exactly
equal to internal and external diseconomies. This
situation arises when after reaching a certain level of
production, economies of scale are balanced by
diseconomies of scale. This is known as homogeneous
production function. Cobb-Douglas linear homogenous
production function is a good example of this kind.

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Law of returns to scale

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