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-
- 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.
- 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.
- 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.
Returns to Factor and Returns to Scale
|Returns to Factor||Returns to Scale|
|2. Nature of Inputs||
|3. Time Element||
|5. Stages of Law||
|6. Causes of Operation||
|7. Scale of Production||