Returns to Scale

RETURNS TO SCALE

Returns to scale: the change in percentage output resulting from a percentage change in all the factors of production. They are increasing, constant and diminishing returns to scale.

Increasing returns to scale may arise: if the output of a firm increases more than in proportionate to an increase in all inputs. For example the input factors are increased by 50% but the output has doubled (100%).

Constant returns to scale: when all inputs are increased by a certain percentage the output increases by the same percentage. For example input factors are increased by 50% then the output has also increased by 50 percentages. Let us assume that a laptop consists of 50 components we call it as a set. In case the firm purchases 100 sets they can assemble 100 laptops but it is not possible to produce more than 100 units.

Diminishing returns to scale: when output increases in a smaller proportion than the increase in inputs it is known as diminishing return to scale. For example 50% increment in input factors lead to only 20% increment in the output.

It is classified into three stages; let us understand the stages in terms of returns to scale.

Stage I:

The total production increased at an increasing rate. We refer to this as increasing stage where the total product, marginal product and average production are increasing.

Stage II:

The total production continues to increase but at a diminishing rate until it reaches the next stage. Marginal product, average product are declining but are positive. The total production is at the maximum level at the end of the second stage with a zero marginal product.

Stage III:

In this third stage total production declines and marginal product becomes negative. And the average production also started decline. Which implies that the change in input factors there is a decline in the over all production along with the average and marginal. Our multiplier must always be positive, and greater than 1, since we want to look at what happens when we increase production.