Returns to Scale

The terms “economies of scale,” “increasing returns to scale,” “constant returns to scale,” “decreasing returns to scale” and “diseconomies of scale” are frequently used. These terms involve subtle and complicated concepts that apply to the long run production process. In principles of economics they are simplified. Conceptually, returns to scale implies that all inputs are variable. Given a Cobb-Douglas production function of the form Q = A Lα Kβ. Q is output or quantity, L is quantity of labour and K is the quantity of capital. A, α and β are parameters that are determined by the technology of producing a specific product. When α + β = 1, the production process demonstrates “constant returns to scale.” If L and K both increased by 10%, output (Q) would also increase by 10%. This is consistent with a long run average cost (envelope) function that has a slope of 0.

When α + β > 1, production has increasing returns. A 10% increase in both L and K results in a larger percentage (say 20%) increase in output (Q).

This is consistent with the declining portion of the long run average cost function (LRAC). This tends to be the result of specialization and division of labour. It is sometimes referred to as economies of scale or economies of mass production. There may be a variety of forces that cause the LRAC to decline. Not all these forces are actually economies of scale. A larger firm (or monopsonist) may be able to negotiate lower prices for inputs. This is not economies of scale, it is a transfer of income or wealth from one group to another.

When α + β < 1, decreasing returns are said to exist. As both inputs increase 10%, output (Q) will increase by a smaller percentage (say 6%). This condition is consistent with the rising portion of the long run average cost function (LRAC). As a firm gets larger it may lack the information about various aspects of the production process and be unable to coordinate all the processes. This is the reason that a planned economy does not always produce optimal results.

increasing returns