Increasing Returns to Scale
Increasing returns to scale is closely associated with economies of scale Increasing returns to scale occurs when a firm increases its inputs, and a more-than-proportionate
increase in production results.
For example, in year one a firm employs 200 workers, uses 50 machines, and produces 1,000 products. In year two it employs 400 workers,
uses 100 machines (inputs doubled), and produces
2,500 products (output more than doubled).
When input prices remain constant, increasing returns to scale results in decreasing long-run average costs (economies of scale). A firm that gets bigger experiences lower costs because of increased specialization, more efficient use of large pieces of machinery (for example, use of assembly lines), volume discounts, and other advantages of producing in large quantities.
Decreasing Returns to Scale
Decreasing returns to scale is closely associated with diseconomies of scale. Decreasing returns to scale happens when the firm's output rises proportionately less
than its inputs rise. For example, in year one, a firm employs 200 workers,
uses 50 machines, and produces 1,000 products. In year two it employs 400 workers, uses 100 machines (inputs doubled), and produces 1,500 products When input prices remain constant, decreasing returns to scale results in increasing long-run average costs (diseconomies of scale).
An organization may become too big, thus creating too many layers of management, too many departments, and too much red tape. This leads to a lack of communications,
inefficiency, delays in decision-making and inefficient production.
Constant Returns to Scale
Constant returns to scale occurs when the firm's output rises proportionate to the increase in inputs. Problem: In the example above, after doubling the inputs in year one, what would output have to be in year two for the firm to experience constant returns to scale? Solution: 2,000 products. At 2,000 products, the output doubles. Because
the inputs double, the increase in production is proportionate. By
definition, this equates
to constant returns to scale.