Long-run production function - Returns to Scale
In the long run, all factors can be changed. Returns to scale studies the changes in output when all factors or inputs are changed. An increase in scale means that all inputs or factors are increased in the same proportion.
The changes in output as a result of changes in the scale can be studied in 3 phases. They are
1. Increasing returns to scale
2. Constant returns to scale
3. Decreasing returns to scale
If the increase in all factors leads to a more than proportionate increase in output, it is called increasing returns to scale. For example, if all the inputs are increased by 5%, the output increases by more than 5% i.e. by 10%. In this case the marginal product will be rising.
If we increase all the factors (i.e. scale) in a given proportion, the output will increase in the same proportion i.e. a 5% increase in all the factors will result in an equal proportion of 5% increase in the output. Here the marginal product is constant.
If the increase in all factors leads to a less than proportionate increase in output, it is called decreasing returns to scale i.e. if all the factors are increased by 5%, the output will increase by less than 5% i.e. by 3%. In this phase marginal product will be decreasing.Figure explains the different phases of returns to scale. When marginal product increases (AB), total product increases at an increasing rate. So there is increasing returns to scale. When Marginal Product remains constant (BC), Total Product increases at a constant rate and this stage is called constant returns to scale. When Marginal Product decreases (CMP), Total Product increases at a decreasing rate and it is called decreasing returns to scale.
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