Returns to Scale Explained

Returns to Scale Explained

🔥NEW Return to scale is a long existing economic concept. Diminishing returns to scale occur if at least one factor is fixed. This means that diminishing returns are typically a short run problem. It measures and reflects the change in output when all factor inputs are varied with the same percentage. They can be classified into 3 forms namely:

1. INCREASING RETURNS TO SCALE. This is experienced when the percentage change in the factor output is greater than the percentage change in the factor input. This is positive to a firm as it results in falling average cost. For example, it could be that the input are increased two fold and the output increases three fold. This is also called economies of scale advantage. This means that when a firm is experiencing increasing returns to scale it will be enjoying lower average cost.
2. DECREASING RETURNS TO SCALE. This is experienced when the percentage change in the factor input is great than the percentage change in the factoroutput. This is negative to a firm as it will result in increasing average cost. For example, when the factor input are increased three fold but the output increases only two fold, the firm is experiencing decreasing returns to scale. This is also called diseconomies of scale. It implies that the firm is now suffering increased average cost.
3. CONSTANT RETURNS TO SCALE. This is experienced when the percentage change in factor input is equal to the percentage change in the output. This means output is changing proportionately to the percentage change in factor input. If for example the factor input is increased two fold and the output also rises two fold, then constant returns to scale are experienced. In this scenario, the average cost remain constant and the average cost curve is flat bottomed.

Sources:
Ferguson, C. E. (1969). "The Neoclassical Theory of Production and Distribution". London: Cambridge University Press. ISBN 978-0-521-07453-7.
Shephard, R.W. (1953) "Cost and production functions". Princeton, NJ: Princeton University Press.
Shephard, R.W. (1970) "Theory of cost and production functions". Princeton, NJ: Princeton University Press.