THE LAW OF RETURNS TO SCALE

A QUICK RECAP . . . .

THE LAW OF VARIABLE PROPORTION IS ALSO KNOWN AS THE LAW OF

RETURNS. THIS LAW DESCRIBES THE BEHAVIOUR OF THE SHORT-RUN PRODUCTION FUNCTION. IT STATES THAT AS WE INCREASE THE AMOUNT OF VARIABLE FACTOR KEEPING THE AMOUNT OF FIXED FACTORS CONSTANT, FIRST THE AVERAGE PRODUCT RISES, THEN IT STARTS FALLING & FINALLY, AN ADDITIONAL UNIT OF VARIABLE FACTOR

RESULTS INTO A FALL IN THE TOTAL OUTPUT, i.e. THE MARGINAL PRODUCT OF
VARIABLE FACTOR BECOMES NEGATIVE. THUS, THE LAW DESCRIBES THREE STAGES NAMELY, 1] STAGE I (STAGE OF INCREASING RETURNS) 2] STAGE II (STAGE OF DIMINISHING RETUNS) & 3] STAGE III (STAGE OF NEGATIVE RETUNS)

THE LAW OF RETURNS TO SCALE

THIS LAW DESCRIBES THE BEHVIOUR OF A LONG-RUN PRODUCTION FUNCTION. IT
STATES THAT AS WE INCREASE ALL THE FACTORS OF PRODUCTION IN A GIVEN PROPORTION, FIRST OUTPUT INCREASES MORE THAN PROPORTIONATELY, THEN IT INCREASES PROPORTIONATELY AND LASTLY, IT INCREASES LESS THAN PROPORTIONATELY. FOR EXAMPLE, WE INCREASE ALL THE INPUTS BY 10%, OUTPUT INCREASES BY MORE THAN 10%, SAY BY 15% OR 20%. THEN IT RISES BY 10% AND LASTLY,

INCREASE IN ALL THE INPUTS BY 10% RESULTS INTO LESS THAN 10% RISE IN THE
OUTPUT. THUS, THE LAW OF RETURNS TO SCALE DESCRIBES THE THREE STAGES, 1] STAGE I (STAGE OF INCREASING RETURNS TO SCALE) 2] STAGE II (STAGE OF CONSTANT RETURNS TO SCALE) 3] STAGE III (STAGE OF DIMINISHING RETURNS TO SCALE)

THESE THREE STAGES CAN BE EXPLAINED WITH THE HELP OF ECONOMIES OF SCALE. THE CONCEPT OF ECONOMIES OF SCALE MEANS, AS WE INCREASE THE SCALE i.e. THE LEVEL OF OUTPUT, THE AVERAGE COST OF PRODUCTION FALLS DUE TO

CERTAIN ADVANTAGES ASSOCIATED WITH LARGE-SCALE PRODUCTION.

THESE ECONOMIES OF SCALE ARE OF TWO TYPES; 1) INTERNAL ECONOMIES OF SCALE 2) EXTERNAL ECONOMIES OF SCALE INTERNAL ECONOMIES OF SCALE ARE THOSE ADVANTAGES WHICH ARE ENJOYED BY THE FIRM THAT EXPANDS. SO. INTERNAL ECONOMIES OF SCALE ARE FIRM-SPECIFIC.

EXTERNAL ECONOMIES OF SCALE ARE NOT FIRM-SPECIFIC. THEY ARE

ENJOYED BY ALL THE FIRMS IN THE INDUSTRY AS A RESULT OF EXPANSION.

INTERNAL ECONOMIES OF SCALE 1. SPECIALISATION & DIVISION OF LABOUR 2. MANAGERIAL ECONOMIES OF SCALE 3. FINANCIAL ECONOMIES OF SCALE

4. MARKETING ECONOMIES OF SCALE

5. LEARNING CURVE EFFECT 6. COMMERCIAL ECONOMIES OF SCALE

EXTERNAL ECONOMIES OF SCALE 1. ECONOMIES OF CONCENTRATION 2. ECONOMIES OF INFORMATION 3. ECONOMIES OF DISINTEGRATION

A FIRM IS BENEFITED BY BOTH INTERNAL AND EXTERNAL ECONOMIES OF SCALE

ONLY UPTO A POINT. THEREAFTER, A FURTHER INCREASE IN THE VOLUME OF OUTPUT STARTS PRODUCING DISECONOMIES OF SCALE. EVEN DISECONOMIES OF SCALE ARE ALSO INTERNAL AS WELL AS EXTERNAL. INTERNAL DISECONOMIES OF SCALE ARE IN THE FORM OF LACK OF PROPER CONTROL OR DISCIPLINE, MISMANAGEMENT, MORE REGULATION OR RESTRICTIONS BY THE GOVERNMENT, GREATER PRESSURE FROM TRADE UNIONS, SUPPLIERS ETC.

EXTERNAL DISECONOMIES OF SCALE ARISE AS A RESULT OF OVERCROWDED AREA, NON-AVAILABILITY OF THE REQUIRED RAW-MATERIAL,

ELECTRICITY, COMPONENTS ETC. IN SUFFICIENT QUANTITY, DELAY IN

TRANSPORT AND SO ON AND SO FORTH.

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SOME INPUTS ARE SUCH THAT THEIR QUANTITY CAN NOT BE INCREASED IN THE SHORT-RUN. e.g. THE SIZE OF PLANT, HEAVY MACHINERY etc. THEY ARE CALLED FIXED FACTORS.

SO, IN ORDER TO INCREASE THE VOLUME OF OUTPUT IN

THE SHORT-RUN, THE PRODUCER HAS TO KEEP THE QUANTITY OF FIXED FACTORS CONSTANT AND INCREASE THE QUANTITY OF THOSE INPUTS THAT CAN BE INCREASED EVEN IN THE SHORT-RUN. SUCH FACTORS ARE CALLED VARIABLE FACTORS, e.g. MANUAL LABOUR. SHORT-RUN PRODUCTION FUNCTION IS ONE IN WHICH AT LEAST ONE FACTOR IS FIXED.

A SHORT-RUN PRODUCTION FUNCTION IS EXPRESSED AS,

Q = f ( L, K )
A LONG-RUN FUNCTION IS ONE WHERE ALL FACTORS ARE VARIABLE.

Q = f ( L, K )

LINEAR PRODUCTION FUNCTION IS ONE WHERE

OUTPUT INCREASES IN THE SAME PROPORTION AS INPUT. FOR EXAMPLE, IN THE SHORT-RUN, CAPITAL IS THE

FIXED FACTOR, SO IF THE VARIABLE FACTOR LABOUR

INCREASES BY 10%, OUTPUT ALSO INCREASES BY 10%. IN THE LONG RUN, IF LABOUR & CAPITAL INCREASE BY 10%, OUTPUT ALSO INCREASES BY 10% IN A NON-LINEAR PRODUCTION FUNCTION,

INCREASE IN LABOUR BY 10% WILL RESULT INTO EITHER

LESS THAN OR MORE THAN 10% INCREASE IN THE OUTPUT.

HOMOGENEOUS PRODUCTION IS ONE IN WHICH ALL THE INPUTS

CHANGE IN THE SAME PROPORTION. IN NON-HOMOGENEOUS PRODUCTION FUNCTION ALL THE INPUTS DO NOT VARY IN THE SAME PROPORTION.