Increasing Returns to Scale

Increasing returns to scale is closely associated with economies of scale (the downward sloping part of the long-run average total cost curve in the previous section).

Increasing returns to scale occurs when a firm increases its inputs, and a more-than-proportionate increase in production results. For example, in year one a firm employs 200 workers, uses 50 machines, and produces 1,000 products. In year two it employs 400 workers, uses 100 machines (inputs doubled), and produces 2,500 products (output more than doubled).

When input prices remain constant, increasing returns to scale results in decreasing long-run average costs (economies of scale). A firm that gets bigger experiences lower costs because of increased specialization, more efficient use of large pieces of machinery (for example, use of assembly lines), volume discounts, and other advantages of producing in large quantities.

Decreasing Returns to Scale

Decreasing returns to scale is closely associated with diseconomies of scale (the upward part of the long-run average total curve). Decreasing returns to scale happens when the firm’s output rises proportionately less than its inputs rise. For example, in year one, a firm employs 200 workers, uses 50 machines, and produces 1,000 products. In year two it employs 400 workers, uses 100 machines (inputs doubled), and produces 1,500 products (output less than doubled).

When input prices remain constant, decreasing returns to scale results in increasing long-run average costs (diseconomies of scale). An organization may become too big, thus creating too many layers of management, too many departments, and too much red tape. This leads to a lack of communications, inefficiency, delays in decision-making, and inefficient production.

Constant Returns to Scale

Constant returns to scale occurs when the firm’s output rises proportionate to the increase in inputs.

Problem: In the example above, after doubling the inputs in year one, what would output have to be in year two for the firm to experience constant returns to scale?

Solution: 2,000 products. At 2,000 products, the output doubles. Because the inputs double, the increase in production is proportionate. By definition, this equates to constant returns to scale.