RETURNS TO SCALE

Reasons for Increasing Returns to Scale

Indivisibility- means that certain factors are available only in some minimum
sizes. Certain inputs particularly machinery, management etc are available in large
and lumpy units. Such inputs cannot be divided into small sizes to suit the scale of
production. For example the cannot be half machinery or half manager. Such
inputs have to be employed even if production is small. Therefore as the scale of
production increases, these indivisible factors are utilized better and more
efficiently. This leads to increasing returns to scale.

Greater specialization- Another cause is greater degree of specialization of labour

and machinery .as the scale of production increases, the efficiency of the labour
increases due to division and specialization of labour.similary as the scale of
production increases it becomes possible to use specialized machinery and services
of specialized and expert management. This results in increasing productivity of
inputs leading to increasing returns to scale.

Causes for decreasing returns to scale

Complexity in management-increasing returns to scale beyond a point may create

the problem of proper management, leading to decrease in managerial efficiency.
Large scale of production creates the problem of lack of proper coordination, large
bureaucracy, and lengthy chain of communication between top management and
the men in production line. As a consequences of all this, the overall efficiency
decreases.
 Entrepreneur is a fixed factor- According to some economists decreasing returns
to scale arises because entrepreneur is an indivisible factor. An increase in scale
may come to a point where the abilities and skills may be fully utilized.

REASONS FOR RETURNS TO FACTOR

Causes for Increasing Returns

1. Optimum utilization of fixed factors-there is always an optimum combination of

variable factors with fixed factors and return to any variable factor will not be
optimum unless factor combination is optimum. Therefore initially, when variable
factor units improves the system and total output increases at an increasing rate.

2. Division of labour (factor units) increases efficiency – when more and more
units of variable factors are applied, it leads to increase in efficiency of factors.eg.
if variable factor is labour, more and more units of labour will lead to division of
labour which in turn increases efficiency.

Causes of Diminishing Returns

1. Disturbance in optimum combination of factors- if variable factor is further

increased; the system again deteriorates and returns to the factor starts diminishing.

2. Factors of productions are not perfect substitute of each other- if the factors of
production are perfect substitute for each other, any factor , including the variable
factor , could be applied to any extent. In that case beyond a needed limit, it would
have worked for other factors. But the factors are not perfect substitute and so the
 applications of any factor beyond desired limit becomes not of much use and it
gets diminishing returns.

Causes of negative returns

1. Overcrowding- if the firm keeps on increasing the variable factors even after
getting diminishing returns , there is overcrowding of variable factors (labour)
resulting in lower availability of tool per labourer. This reduces the efficiency of
the labour and hence return to additional worker becomes negative.

2. Mismanagement- continuous increase in variable factors on a given amount of

fixed factor creates the problem of mismanagement in the whole system. The
additional unit of variable factor may become uncontrollable and unmanageable.
This results in loss of efficiency and negative returns.

Scale of production

The term scale of production means the size or the volume of the production in
the firm. The actual scale of production of a firm is determined by technological
as well as market forces. The importance of technology in determining the scale
of production is easily understood. For instance , in a modern oil refinery, a
large no. of complex machines have to be used. These involves a huge amount
of capital expenditure. Such a large investment doesn’t become
profitable unless volume of production is too large. Thus, the nature of
technology sometimes dictates large-scale production. On the other hand, it may
permit small- scale production in some areas.

The importance of the market is also emphasized in this connection. A

commodity which is in great demand in the market will be produced in large
quantities.

Of course, this doesn’t necessarily imply large- scale production because there
can be many small firms, each producing on a small- scale, but together
producing a large total amount of the commodity.

Internal and external economies of scale

When the scale of production increases, the producer reaps some benefits. these
benefits reduces their average cost of production. These are called as Economies
of scale. Economies of scale are of two types:_

1) Internal Economies of Scale:

Definition and Types:

Internal economies of scale are those economies which are internal to the firm.
These arise within the firm as a result of increasing the scale of output of the
firm. A firm secures these economies from the growth of the firm
independently. The main internal economies are grouped under the following
heads:
(i) Technical Economies: When production is carried on a large scale, a firm
can afford to install up to date and costly machinery and can have its own
repairing arrangements. As the cost of machinery will be spread over a very
large volume of output, the cost of production per unit will therefore, be low.

A large establishment can utilize its by products. This will further enable the
firm to lower the price per unit of the main product. A large firm can also secure
the services of experienced entrepreneurs and workers which a small firm
cannot afford. In a large establishment there is much scope for specialization of
work, so the division of labor can be easily secured.

(ii) Managerial Economies: When production is carried on a large scale, the

task of manager can be split up into different departments and each department
can be placed under the supervision of a specialist of that branch. The difficult
task can be taken up by the entrepreneur himself. Due to this functional
specialization, the total return can be increased at a lower cost.

(iii) Marketing Economies: Marketing economies refer to those economies

which a firm can secure from the purchase or sale of the commodities. A large
establishment is in a better position to buy the raw material at a cheaper rate
because it can buy that commodity on a large scale. At the time of selling the
produced goods, the firm can secure better rates by effectively advertising in the
newspapers, journals and radio, etc.

(iv) Financial Economies: Financial economies arise from the fact that a big
establishment can raise loans at a lower rate of interest than a small
establishment which enjoys little reputation in the capital market.

(v) Risk Bearing Economies: A big firm can undertake risk bearing economies
by spreading the risk. In certain cases the risk is eliminated altogether. A big
establishment produces a variety of goods in order to cater the needs of different
tastes of people. If the demand for a certain type of commodities slackens, it is
counter balanced by the increase in demand of the other type of commodities
produced by the firm.

(vi) Economies of Scale: As a firm grows in size, it is-possible for it to reduce

its cost. The reduction in costs, as a result of increasing production is called
economies of scale. The economies of scale are obtained by the firm up to the
lowest point on the firms long run average cost curve. The main sources of
economies of scale are in brief as under.:

Diseconomies of Scale:
Definition:

The extensive use of machinery, division of labor, increased specialization and

larger plant size etc., no doubt entail lower cost per unit of output but the fall in
cost per unit is up to a certain limit. As the firm goes beyond the optimum size,
the efficiency of the firm begins to decline. The average cost of production
begins to rise.

Factors of Diseconomies:

The main factors causing diseconomies of scale and eventually leading to

higher per units cost are as follows:

(i) Lack of co-ordination. As a firm becomes large scale producer, it

faces difficulty in coordinating the various departments of production. The lack
of co-ordination in the production, planning, marketing personnel, account, etc.,
lowers efficiency of the factors of production. The average cost of production
begins to rise.

(ii) Loose control. As the size of plant increases, the management loses control
over the productive activities. The misuse of delegation of authority, the
redtapisim bring diseconomies and lead to higher average cost of production.

(iii) Lack of proper communication. The lack of proper communication

between top management and the supervisory staff and little feed back from
subordinate staff causes diseconomies of scale and results in the average cost to
go up.

(iv) Lack of identification. In a large organizational structure, there is no close

liaison between the top management and the thousands of workers employed in
the firm. The lack of identification of interest with the firm results in the per unit
cost to go up.

(2) External Economies of Scale:

Definition and Types:

External economies of scale are those economies which are not specially
availed of by .any firm. Rather these accrue to all the firms in an industry as the
industry expands. The main external economies are as under:
(i) Economies of localization. When an industry is concentrated in a particular
area, all the firms situated in that locality avail of some common economies
such as (a) skilled labor, (b) transportation facilities, (c) post and telegraph
facilities, (d) banking and insurance facilities etc.

(ii) Economies of vertical disintegration. The vertical disintegration

implies the splitting up the production process in such a manner that some Job
are assigned to specialized firms. For example, when an industry expands, the
repair work of the various parts of the machinery is taken up by the various
firms specialists in repairs.

(iii) Economies of information. As the industry expands it can set up research

institutes. The research institutes provide market information, technical
information etc for the benefit of alt the firms in the industry.

(iv) Economies of by products. All the firms can lower the costs of production
by making use of waste materials.

External Diseconomies:
Definition:

A firm or an industry cannot avail of economies for an indefinite period of time.

With the expansion and growth of an industry, certain disadvantage also begin
to arise. The diseconomies of large scale production are:

(i) Diseconomies of pollution, (ii) Excessive pressure on transport facilities, (iii)

Rise in the prices of the factors of production, (iv) Scarcity of funds, (v)
Marketing problems of the products, (iv) Increase in risks.

Internal and External Economies Of scale:

When an increase in the scale of production results in a more than proportionate
increase in output the firm is said to be experiencing economies of scale.

There are two types of Economies of scale

Internal Economies of scale

External Economies of scale
Internal Economies of scale are those which arise from the growth of the firm
independently of what is happening to the other firms. They simply arise from
an increase in the scale of production in the firm itself. A firm may grow as a
result of increasing the number of workplaces it has or increase the size of its
plants.

External Economies of scale are those advantages in the form of lower average
costs which a firm gains from the growth of the industry. These economies are
available to all the firms in the industry independently of change in the scales of
their individual output.

Internal economies of scale can be divided into technical economies, marketing

economies, financial economies, research and development economies,
managerial economies and risk bearing economies.

External Economies of scale are especially significant when industries are

heavily localized in industrial clusters. Example of economies of scale includes
labor, ancillary services, disintegration, cooperation, commercial facilities and
specialized market.

Internal and External Diseconomies Of scale:

When an increase in the scale of production results in a less than proportionate
increase in output the firm is said to be experiencing diseconomies of scale

There are also two types of diseconomies of scale

Internal Diseconomies of scale

External Diseconomies of scale
Internal diseconomies of scale occur when the firm grows beyond its optimum
size, efficiency declines and average cost begin to rise. The main problems
which arise when a firm grows too large are thought to be mainly attributable to
management difficulties. As the size of the firm increases, management
becomes more and more complex. It becomes increasingly difficult to carry out
the management function of coordination, control, communication and to
maintain good industrial relations.

External diseconomies of scale are when a firm experience disadvantage as a

result of the industry to which it belongs becoming too large. For example
shortage of labor with the appropriate skills, increasing demand for raw material
may also bid up the prices and cause cost to rise; land for expansion will become
increasingly scare and hence more expensive both to purchase and to rent.
Transport cost may also rise because of increased congestion. All firms in the
industry whether they are seeking to expand or not, may suffer rising cost as a
result of the industry getting large too quickly.