RETURNS TO SCALE

(Long-run Production Function)

Returns to scale describes the changes in output when
all inputs are changed in the same proportion. For
example, if one worker operates 2 machines, then 2
workers will operate 4 machines and 3 workers will
operate 6 machines and so on.
• Assumptions:-
1. All factors are variable but enterprise is fixed.
2. There is no change in technology.
3. Perfect competition prevails in the market.
4. Returns are measured in physical terms.
 Explanation of the law
The long run production function describes
the changes in output when all the inputs are
varied at the same production.When inputs
are increased in the same proportion and the
scale of production is expanded, the effect on
output shows three stages. Firstly, increasing
returns to scale, then constant returns to scale
and then diminishing returns to scale.
Stage 1:- Increasing Returns to scale:- Increasing
returns to scale happens when an increase in
all factors in a given proportion causes a more
than proportionate increase in output. For
example, when inputs are increased 100% and
output increases by more than 100%, we call
it as increasing returns to scale.
Stage 2:- Constant Returns to Scale:- Constant
returns to scale happens when an increase in
all factor inputs in a given proportion causes
an equal and proportionate increase in
output. For example, when inputs are
increased 100% and output increases by same
100%. We call it as constant returns to scale.
Stage 3:- Diminishing Returns to Scale;-
Diminishing returns to scale happens when an
increase in all factor inputs in a given
proportion causes a less than proportionate
increase in output. For example, when inputs
are increased 100% and output increases by
less than 100%, we call it as diminishing
returns.
Why do different Returns to Scale Operate?
Increasing returns to scale operates because when
scale production expands, there will be Specialisation and
Division of Labour. The firm will enjoy Internal economies
of scale and external economies of scale.
Internal economies of scale refers to the advantages or
benefits which accrue to a firm as a result of an increase in
the scale of production. External economies of scale are
those benefits that arise from the expansion in the size of
the firm which are shared by all the firms in the industry.
When the scale of production increases beyond the
optimum capacity, diseconomies of scale (both internal and
external) will operate. Difficulties in management and co-
ordination, ineffective supervision etc. will result in a less
than proportionate increase in output.
 ECONOMIES OF SCALE
It is a common experience of every producer that costs
can be reduced by increased production. That is why the
producers are more keen on expanding the scale of
production. In the process of expansion, the producer may
benefit from the emergence of economies of scale.
Economies of scale refer to the advantages or benefits
arise from the expansion in the size of the firm.
Economies of scale are broadly classified into two types.
1.Internal Economies and 2.External Economies.
Internal economies are those advantages which are
enjoyed by a particular firm when its scale of production
expands. On the other hand, external economies refer to
the advantages or gains accruing to all firms in an
industry due to the growth of that industry.
 Internal Economies
When a firm expands its scale of production,
the economies which accrue to this firm are
known as Internal Economies. According to
Cairncross, “internal economies are those which
are open to a single firm independently of the
action of other firm. They result from an increase
in the scale of output of the firm, and cannot be
achieved unless output increases. They are not
the result of inventions of any kind, but are due
to the use of known methods of production
which a small firm does not find worthwhile.”
 Types of Internal Economies
1.TECHNICAL ECONOMIES:-
Technical economies are those which accrue to a firm from
the use of better machines and techniques of production. As a
result, production increases and cost per unit of production
decreases. Following Cairncross, we may classify the various kinds
of technical economies as follows:
@1.Economies of Increased Dimensions:-
Certain technical economies may arise on account of increased
dimensions. For example, a double decker bus is more economical
than a single decker. One driver and one conductor may be needed,
whether it is a double decker or a single decker bus.
@2.Economies of Linked Processes:-
As a firm increases its scale of operation, it can properly be
linked to various production processes more efficiently. For
example, in order to obtain the advantage in a linkage process, both
editing and printing of newspapers are generally carried out in the
same premises.
@3.Economies of the Use of Bye-Product:-
A large firm is in a better position to utilise the by-products
efficiently and attempt to produce another new product. For example, in a
large sugar factory, the molasses left over after the manufacture of sugar
from sugarcane can be used for producing alcohol by installing a small
plant.
@4.Economies in Power(Electricity):-
Large sized machines without continuous running are more
economical than small sized machines running continuously in respect of
power consumption. For example, a big boiler consumes more or less the
same power as that of a small boiler but gives more heat.
@5.Economies of Increased Specialisation:-
A large firm can divide the work into various sub-processes.
Therefore, divison of labour and specialisation become possible. At one
stroke all the advantages of division of labour can be achieved. For
example, only a well established big school can have specialised teachers.
@6.Economies of Continuation:-
Technical economies are also realised due to a
long-run continuation of the production process.
For example, composing and printing of 1000
copies may cost Rs.200; but if we increase the
number of copies to 2000, it may cost only
Rs.250, because the same sheet plate which has
been composed previously can be utilised for the
increased number of copies also.
2.LABOUR ECONOMIES:-
A large firm employs a large number of labourers. Therefore, each
person can be employed in the job to which he is most suited. More-over,
a large firm is in a better position to attract specialised experts into the
industry. Likewise, specialisation saves time and encourages new
inventions. All these advantages result in lower costs of production.
3.MARKETING ECONOMIES:-
These Economies are achieved by a large firm both in buying raw
materials as also in selling its finished products. If the large firm
purchases its requirements in bulk, it can bargain on its purchases on
favourable terms. It can bargain on its purchases on favourable terms. It
can ensure continuous supply of raw materials. It is eligible for
preferential treatment. The special treatment may be in the form of
freight concessions from transport companies, adequate credit from
banks and other financial institutions etc. In terms of advertisements also
it is better placed than the smaller firms. Better trained and efficient sales
persons can be appointed for promoting sales.
4.FINANCIAL ECONOMIES:-
The credit requirements of the big firms can be met from
banks and other financial institutions easily. A large firm is able to
mobilise much credit at cheaper rates. Firstly, investors have more
confidence in investing money in the well established large firms.
Secondly, the shares and debentures of a large firm can be
disbursed or sold easily and quickly in the share market.
5.MANAGERIAL ECONOMIES:-
On the managerial side also economies can be achieved; when
output increases, specialists can be more fully employed. A large
firm can divide its big departments into various sub-departments
and each department may be placed under the control of an
expert. A brilliant organiser can devote himself wholly to the work
of organising while the routine jobs can be left to relatively low
paid workers.
6.RISK-BEARING ECONOMIES:-
The larger the size of a firm, the more likely are its losses to be
spread among its various activities according to the law of averages. A big
firm produces a large number of items and of different varieties so that
the loss in one can be counter balanced by the gain in another. For
example, a branch bank can spread its risk by diversification of its
investment portfolio rather than a unit bank. Suppose a bank in a
particular locality is facing “a run on the bank”, it can recall its resources
from other branches and can easily overcome the critical situation. Thus,
diversification avoids “putting all its eggs in one basket”.
7.ECONOMIES OF RESEARCH:-
A LARGE SIZED FIRM CAN SPEND MORE MONEY ON ITS RESEARCH
ACTIVITIES. It can spend huge sums of money in order to innovate new
varieties of products or improve the quality of the existing products. In
cases of innovation it will become an asset of the firm. New innovations or
new methods of producing a product may help to reduce its average costs.
8.ECONOMIES OF WELFARE:-
A large firm can provide welfare facilities
to its employees such as subsidised housing,
subsidised canteens, creches for the infants of
women workers, recreation facilities etc; all
these measures have an indirect effect on
increasing production and at reducing the
costs.
 EXTERNAL ECONOMIES
External economies refer to gains accruing to all the firms in an
industry due to growth of that industry. External economies can be
enjoyed by all the firms in the industry irrespective of their size. The
emergence of external economies is due to localisation.
The main types of external economies are as follows:
1.Economies of concentration:-
When a number of firms are located in one place, all the
member firms reap some common economies.
Firstly, skilled and trained labour become available to all the firms.
Secondly, banks and other financial institutions may set up their
branches, so that all the firms in the area can obtain liberal credit
facilities easily.
Thirdly, the transport and communication facilities may get improved
considerably.
Further, the power requirements can be easily met by the electricity
boards.
Lastly, supplementary industries may emerge to assist the main
industry.
2.Economies of Information:-
The economies of information may arise as a result of the collective
efforts of the various firms. Firstly, an individual firm may not be in a
position to spend enormous amounts on research. But by pooling all their
resources, new findings and inventions may become possible. The fruits of
the invention can be shared by all the member firms. Secondly, publication
of statistical, technical and marketing information will be of vital
importance to increase output at lower costs.
3.Economies of Disintegration:-
When the industry grows, it becomes possible to split up production
into several processes and leave some of the processes to be carried out
more efficiently by specialised firms. This makes specialisation possible
and profitable. For example, in the cotton teXtile industry, some firms may
specialise in manufacturing thread, some in producing dhoties, some in
knitting banians, some in weaving sarees. The disintegration may be
horizontal or vertical. Both will help the industry in avoiding duplication
and in saving time and materials.
 DISECONOMIES OF LARGE_SCALE
PRODUCTION
A firm cannot reap economies of scale
indefinitely. There is a limit to production
beyond which it is counteractive in the sense
that internal and external economies may
turn out to be diseconomies. These
counteractive forces may become responsible
for increased costs of production. These
factors are known as internal and external
diseconomies.
1.Difficulties of Management:-
If production continues, beyond a particular
stage, a chain of complex problems may arise
giving rise to increased costs. Supervision
becomes lax, complex and intractable, red-
tapism and wastage arise, workers may become
indifferent and the rapport between workers
and management may disappear. All these
activities result in raising average costs.
2.Marketing Diseconomies:-
The expansion of a firm beyond a certain limit
may also lead to marketing problems. Raw
materials may not become available at the right
time and in sufficient quantities. More-over,
since the firms are operating in a monopolistic
world, they have to face stiff and cut throat
competition from their rivals. Therefore,
expensive advertising and sales promotion
measures may have to be undertaken and it may
ultimately lead to higher costs.
3.Financial Diseconomies:-
Finance is the life blood of any organisation. For
expanding business, the entrepreneur needs enormous
amount of fresh capital. But finance in the required
amount and at the appropriate time may not easily be
forthcoming. This may retard the development of the firm’s
growth.
4.Technical Diseconomies:-
There is a limit to the division of labour and splitting
down of the production processes. Beyond a range, further
technical economies may not be beneficial and a
disproportionate expansion may result in technical
diseconomies..
5.Increased Risk:-
As the size of a firm expands, risks also may
increase by leaps and bounds. If the production
manager or sales manager miscalculates market
trends, sales will suffer which may lead to heavy
losses.
6.External Diseconomies:-
The growth and localisation of industries
ultimately lead to increased demand for labour,
finance, raw materials, power, transport etc. Thus,
competition among the various firms tend to increase
the cost per unit.