Returns to scale
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In economics, returns to scale and long run average total cost are related but different concepts that describe what happens as the scale of production increases in the long run, when all input levels including physical capital usage are variable (chosen by the firm). The concept of returns to scale arises in the context of a firm's production function. It explains behavior of the rate of increase in output (production) relative to the associated increase in the inputs (the factors of production) in the long run. In the long run all factors of production are variable and subject to change due to a given increase in size (scale). While economies of scale show the effect of an increased output level on unit costs, returns to scale focus only on the relation between input and output quantities.
There are three possible types of returns to scale: increasing returns to scale, constant returns to scale, and diminishing (or decreasing) returns to scale. If output increases by the same proportional change as all inputs change then there are constant returns to scale (CRS). If output increases by less than that proportional change in all inputs, there are decreasing returns to scale (DRS). If output increases by more than the proportional change in all inputs, there are increasing returns to scale (IRS). A firm's production function could exhibit different types of returns to scale in different ranges of output. Typically, there could be increasing returns at relatively low output levels, decreasing returns at relatively high output levels, and constant returns at one output level between those ranges.
In mainstream microeconomics, the returns to scale faced by a firm are purely technologically imposed and are not influenced by economic decisions or by market conditions (i.e., conclusions about returns to scale are derived from the specific mathematical structure of the production function in isolation).
When the usages of all inputs increase by a factor of 2, new values for output will be:
- Twice the previous output if there are constant returns to scale (CRS)
- Less than twice the previous output if there are decreasing returns to scale (DRS)
- More than twice the previous output if there are increasing returns to scale (IRS)
Assuming that the factor costs are constant (that is, that the firm is a perfect competitor in all input markets) and the production function is homothetic, a firm experiencing constant returns will have constant long-run average costs, a firm experiencing decreasing returns will have increasing long-run average costs, and a firm experiencing increasing returns will have decreasing long-run average costs. However, this relationship breaks down if the firm does not face perfectly competitive factor markets (i.e., in this context, the price one pays for a good does depend on the amount purchased). For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range.
Formally, a production function is defined to have:
- Constant returns to scale if (for any constant a greater than 0) (Function F is homogeneous of degree 1)
- Increasing returns to scale if (for any constant a greater than 1)
- Decreasing returns to scale if (for any constant a greater than 1)
where K and L are factors of production—capital and labor, respectively.
In a more general set-up, for a multi-input-multi-output production processes, one may assume technology can be represented via some technology set, call it , which must satisfy some regularity conditions of production theory. In this case, the property of constant returns to scale is equivalent to saying that technology set is a cone, i.e., satisfies the property . In turn, if there is a production function that will describe the technology set it will have to be homogeneous of degree 1.
The Cobb–Douglas functional form has constant returns to scale when the sum of the exponents is 1. In that case the function is:
where and . Thus
Here as input usages all scale by the multiplicative factor a, output also scales by a and so there are constant returns to scale.
But if the Cobb–Douglas production function has its general form
with and then there are increasing returns if b + c > 1 but decreasing returns if b + c < 1, since
which for a > 1 is greater than or less than as b+c is greater or less than one.
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