Law of Returns to Scale: Types, Graphs, Examples, for UGC NET

The Law of Returns to Scale states how the output of a firm changes when it increases all its inputs proportionately in the long run. There can be an increasing, constant, or decreasing return to scale.The law of returns to scale plays a crucial role in understanding how businesses grow by changing all inputs proportionately in the long run. Production is a very important activity because it transforms the goods into such a form that it fulfills the needs of the consumer. All the factors of production, in the long run, are variable. So, the scale of production can be changed according to the changes in the quantity of all factors of production. The law of returns to scale is the proportionality change in the output due to the changes in the inputs. There are increasing, decreasing, and constant returns to scale. Raw materials of various kinds go through a production process, and then it is converted into good that attracts consumers. The law of returns to scale means that the output changes according to the changes in all the inputs. It is a factor that measures changes in productivity due to the change in call production inputs over time.

The law of returns to scale is a topic that holds utmost importance in the UGC NET Commerce exam. It is a part of the commerce paper 2 syllabus of the UGC NET exam. You can check the commerce syllabus.

In this article, we will learn about the following:

• What is the Law of Returns to Scale?
• Returns to Scale Graph
• The Returns to Scale Law in Production Functions
• Three Stages of Returns to Scale
• Assumptions of Return to Scale
• Meaning of Short Run and Long Run

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What is the Law of Returns to Scale?

The ‘Law of Returns to Scale’, is an economic concept that describes how the production of a company will change when all resources employed to produce goods are augmented by the same proportion. For instance, if a factory doubles the number of machines and employees, how much extra will it produce? At the initial stage, if a firm raises its resources, its output (or production) will also go up at an accelerating rate. This is referred to as ‘increasing returns to scale’. Beyond a point, though, increasing more resources does not result in greater marginal growth in production, and it might even deteriorate. This is referred to as ‘decreasing returns to scale’. There is also a point in between where output grows at the same rate as the resources, known as ‘constant returns to scale’. The law assists companies in knowing how to expand effectively and when they should cease to expand resources.

A ‘Returns to Scale graph’, illustrates how the production of a company varies when all resources are increased by the same proportion. It informs us about whether more resources result in more, less, or the same level of production. The graph below visually illustrates the law of returns to scale through its three stages: increasing, constant, and decreasing.

Fig: law of returns to scale

The Returns to Scale Law in Production Functions

The Law of Returns to Scale determines what proportionally increasing all inputs, such as labor and capital, produces in terms of the output of the system in the long run. This is a law for the long run and does not operate at all for the short run and hence can be compared to Law of Variable Proportions (single input variable) since all factors of production are variable in the long run.

Types of Returns to Scale

Returns to Scale refers to how output responds when all inputs are increased simultaneously.

It is classified into three types: increasing, constant, and decreasing returns to scale based on the proportion of output to input change.

1. Increasing Returns to Scale (IRS) – Output increases more than proportionately compared to inputs.
2. Constant Returns to Scale (CRS) – Output increases in exact proportion to inputs.
3. Decreasing Returns to Scale (DRS) – Output increases less than proportionately to the increase in inputs.

Table: Illustration of Returns to Scale

The table below demonstrates how output changes with different levels of input under each type of returns to scale. It helps visualize the concept using real numerical examples for better understanding.The following table provides a simple numerical demonstration of the law of returns to scale using real-world data.

Interpretation:

As seen from the figures, the law of returns to scale categorizes production efficiency into increasing, constant, and diminishing output behavior.

• Increasing Returns to Scale (IRS):
  • From Row 1 to Row 3 (Inputs: 1→3, Capital: 2→6; Output: 10→40):
  • The inputs grow by Figure 50 and 100%, the outputs develop Figure 150 and Figure 60, that is more than proportionate. The nature of the Returns is Increasing, meaning the company has gained efficiency as it grows.
• Constant Returns to Scale (CRS):
  • From Row 3 to Row 5 (Inputs increase 33% and 25% Output increases 37.5% and 27.2%):
  • Herein lies the case wherein the percentage increase in output is almost leveled as the percentage increase in inputs. It states Constant Returns to Scale wherein outputs grow in the same proportion as inputs.
• Diminishing Returns to Scale (DRS):
  • From Row 5 to Row 7 (Inputs increase by 20% and 16.6%; Output increases by just 11.4% and 6.4%):
  • Output is increasing less than the inputs, indicating falling efficiency with each added unit. This stage is called Diminishing Returns to Scale.
• Summary: 
  • IRS = Output ↑ faster than inputs ↑ Business becomes more efficient.
  • CRS = Output ↑ equal to inputs ↑ Efficiency stays constant. 
  • DRS = Output ↑ less than inputs ↑ Efficiency is diminishing.

Three Stages of Returns to Scale

Returns to scale describe how a company's production varies when all the inputs, such as land, labor, and capital, are added in larger amounts. There are three stages of returns to scale: increasing returns to scale, constant returns to scale, and decreasing returns to scale. These three stages enable firms to know how increased production impacts their output and efficiency.

Increasing Returns to Scale (IRS)

The first stage is called increasing returns to scale, where output increases more than proportionately compared to inputs. During the phase of increasing returns to scale, as a firm expands all inputs, it expands output at an escalating rate. This is due to the fact that firms make the most of resources, incurring reduced costs and increased productivity. For example, if doubling workers and machines results in triple output, the firm is enjoying increasing returns to scale.This tends to happen during the initial period of business growth when technology and specialization enhance productivity. Firms gain the maximum during this period as they have more output for the same amount of inputs.

Constant Returns to Scale (CRS)

In the phase of constant returns to scale, a rise in all inputs gives rise to the same proportionate increase in output. That implies that if a business doubles both its machines and employees, so does its output. Companies in this phase are at an optimum level of production such that they are not achieving additional benefits but neither are they suffering from inefficiencies. A case in point is a bakery that doubles both ingredients, ovens, and employees but also outputs precisely double the number of cakes. The bakery is witnessing constant returns to scale. This phase is typical when a company has utilized all of its resources and keeps producing at a constant rate. 

Decreasing Returns to Scale (DRS)

For the phase of decreasing returns to scale, when a firm expands all inputs, the production increases at a decreasing pace. This is because there are too many workers or machines which could result in inefficiencies, crowding, or even mismanagement. For instance, if a factory doubles its machines and workers but production rises by just 50%, it is facing diminishing returns to scale. This usually occurs when a firm is too big to be efficiently managed, resulting in increased costs and reduced productivity. Firms at this phase might have to enhance their technology or organization to prevent waste and inefficiencies. 

Assumptions of Return to Scale

The law of returns to scale is based on certain assumptions such as proportional increase in all inputs, constant technology, and no external disruptions. The returns to scale assumptions describe the circumstances under which a company can have increasing, constant, or diminishing returns. The assumptions tell us how a firm can expand and whether its output will rise, remain unchanged, or fall.

All Resources Grow Proportionately

If the law of returns to scale is to hold, then the firm must increase all of its resources, such as employees, equipment, and materials, equally. If some resource is growing at a rate higher than others, then outcomes may not trend the same. This assumption serves to ensure the firm is growing in a symmetric manner. By raising everything proportionally, the firm can observe how it impacts production. This indicates whether the firm is becoming more efficient or not.

Technology Remains the Same

Another assumption is that the technology employed by the business remains the same as the resources are being increased. It implies that the company does not alter its machinery or equipment when it is growing. If the new technology is implemented, then it may have an impact on the usage of the resources. The concern here is only increasing the quantity of resources without modifying the usage. This assists in understanding the real effect of resources being increased on production.

No Change in Management

It is also presumed that the leadership or management of the business remains constant while resources are being added. If the management is changed, it may influence how effectively the resources are utilized. A good manager ensures that the business develops smoothly. This presumption makes sure that any production changes are only due to the added resources, not a shift in leadership. It helps keep the results of growth accurate.

Short-Term Orientation

The returns to scale law tends to assume that the company is interested in the short term. Businesses can observe directly in the short term how a rise in resources impacts production. Long-term implications can differ with new variables such as market conditions or competition entering the picture. This assumption simplifies the examination of returns to scale. It enables companies to strategize growth in the immediate future.

No External Changes

Lastly, the assumption is that there are no external factors influencing the business, such as changes in the economy or legislation. If external factors change, they may impact the way the business expands. This assumption maintains the emphasis on the internal changes of the business. It allows businesses to know how their own activities influence production. This makes the analysis of returns to scale more precise and targeted.

Meaning of Short Run and Long Run

The short run and long run are economic terms referring to the period of time covered by firms and production. For the short run, it is true that some inputs, such as machinery and buildings, cannot be modified, but other inputs, including labor, can. What this implies is that firms can add workers or extend the number of working hours but not immediately increase their plants' capacity. In the long run, any factor of production, such as land, labor, and capital, can be modified. Firms can construct new factories, make new technology investments, or fundamentally alter their method of production. For expenses, the short run enjoys fixed and variable costs, whereas in the long run, all expenses are variable and firms can completely adapt to shifts in demand.

Conclusion

By understanding the law of returns to scale, firms can assess whether increasing inputs leads to efficiency or inefficiency. Law of returns to scale generally evaluate the productivity and efficiency of the firm after the changes in the input level. In the returns to scale, the changes in the output are typically adjusted according to the changes in the inputs. A company is said to be efficient when it produces more levels of output by using the same or less level of input as the company needs to cooperate and maintain the levels of returns to scale as per the requirement of the situation.

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Law of Returns to Scale Previous Year Questions

Increasing returns to scale arise because as the scale of operation increases it causes-

Options. 

1. more division of labour and specialisation
2. production utilisation of machinery
3. lower procurement and logistics costs
4. more difficulties in managing form efficiently
5. more economies in advertising 

Choose the correct answer from the options given below:

• A, B and C only
• C, D and E only
• A, B, C and D only
• A, B, C and E only

Ans. d. A, B, C and E only