CA Foundation Business Economics Study Material – Law of Returns to Scale

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CA Foundation Business Economics Study Material Chapter 3 Theory of Production and Cost – Law of Returns to Scale

Law of Returns to Scale

  • The Law of Returns to Scale examines the production function i.e. the input – output relation in long run where increase in output can be achieved by varying the units of ALL FACTORS IN THE SAME PROPORTION.
  • Thus, in long run all factors become variable.
  • It means that in long run the scale of production and the size of the firm can be increased.

The law of returns to scale analyse the effects of scale on the level of output as-

  1. Increasing Returns to Scale:
    • When the output increases by a greater proportion than the proportion increases in all the factor inputs, it is increasing returns to scale.
    • E.g. When all inputs are increased by 10% and output rises by 30%.
    • The reasons of increasing returns to scale are – internal and external economies of scale; indivisibility of fixed factors; improved organisation; division of labour and specialisation; better supervision and control; adequate supply of productive factors, etc.
  2. Constant Returns to Scale:
    • When the output increases exactly in the same proportion as that of increase in all factor inputs, it is constant returns to scale.
    • E.g. – When all inputs are increased by 10% and output also rises by 10%.
    • The reason of constant returns to scale is that beyond a certain point, internal and external economies are NEUTRALISED by growing internal and external diseconomies.
  3. Diminishing Returns to Scale:
    • When the output increases by a lesser proportion than the proportion increase in all the factor inputs, it is diminishing returns to scale.
    • E.g. When all inputs are increased by 20% but output rises by 10%.
    • The reason of diminishing returns to scale is increased internal and external diseconomies of production.
    • Internal diseconomies like difficulties in management, lack of supervision and control, delay in decision-making etc.
    • External diseconomies like insufficient transport system, high freights, high prices of raw materials, power cuts, etc.

The law of returns to scale can also be illustrated with the help of the following schedule and diagram.
CA Foundation Business Economics Study Material Law of Returns to Scale 1
CA Foundation Business Economics Study Material Law of Returns to Scale 2

Returns to Factor and Returns to Scale

Returns to Factor Returns to Scale
1. Meaning
  • Returns to factor refers to the various production sizes where one factor is variable and other factor of production are fixed.
  • In other words, it examines production function when the output is increased by varying the quantity of one input.
  • It examines the effect of CHANGE IN THE PROPORTIONS between inputs on output.
  • Returns to scale refers to the various production sizes where increase in output can be achieved by varying the units of ALL FACTORS in the SAME PROPORTIONS.
  • It show the effects on output when all factor inputs are varied in the same proportion simultaneously.
2. Nature of Inputs
  • Quantities of some inputs are fixed while the quantities of other inputs vary.
  • In other words, there are FIXED and VARIABLE factors of production.
  • Quantities of all inputs can be varied.
  • In other words, all factors of production are VARIABLE.
3. Time Element
  • Returns to factor is called a SHORT RUN production function.
  • Returns to scale is called a LONG RUN production function.
4. Application
  • It does not apply where the factors must be used in fixed proportion to produce a commodity.
  • It does apply where the factors must be used in fixed proportions to produce a commodity.
5. Stages of Law
  • The law has three stages namely –
    (a)    Increasing Returns to factor,
    (b)   Diminishing Returns to Factor, &
    (c)   Negative Returns to factor ‘
  • Of the three stages, diminishing returns pre-dominate.
  • The law has three stages namely –
    (a)    Increasing Returns to Scale,
    (b)   Constant Returns to Scale,
    (c)   Diminishing Returns to Scale.
  • All the three stages of return appear.
6. Causes of Operation
  • Increasing returns to factor is due to indivisibility of fixed factors and division of labour and specialisation.
  • Diminishing returns is due to non- optimal factor proportion and imperfect substitutability of factors.
  • Negative returns fall in the efficiency of fixed and variable factors.
  • Increasing returns to scale is due to increased internal and external economies.
  • Constant returns to scale is due to the fact that internal and external economies are neutralised by growing internal and external diseconomies.
  • Diminishing returns is due to internal and external diseconomies of scale.
7. Scale of Production
  • The scale of output is unchanged and the production plant or the size and efficiency of the firm remain constant.
  • This is because, only one factor is variable and all other factors are fixed.
  • The scale of output can be increased and so the size of the firm too can be expanded.
  • This is because all factors are variable and hence can be increased in the same proportion simultaneously.