returns to scale

(noun)

A term referring to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor).

Related Terms

Examples of returns to scale in the following topics:

  • Economies and Diseconomies of Scale

    • Increasing, constant, and diminishing returns to scale describe how quickly output rises as inputs increase.
    • Returns to scale explains how the rate of increase in production is related to the increase in inputs in the long run.
    • There are three stages in the returns to scale: increasing returns to scale (IRS), constant returns to scale (CRS), and diminishing returns to scale (DRS).
    • Returns to scale vary between industries, but typically a firm will have increasing returns to scale at low levels of production, decreasing returns to scale at high levels of production, and constant returns to scale at some point in the middle .
    • Identify the three types of returns to scale and describe how they occur

  • Few Sellers

    • An oligopoly - a market dominated by a few sellers - is often able to maintain market power through increasing returns to scale.
    • One source of this power is increasing returns to scale.
    • Most industries exhibit different types of returns to scale in different ranges of output.
    • Cell phone companies have increasing returns to scale, which leads to a market dominated by only a few firms.
    • Explain how increasing returns to scale will cause a higher prevalence of oligopolies

  • Defining the Production Function

    • This is also known as diminishing returns to scale - increasing the quantity of inputs creates a less-than-proportional increase in the quantity of output.
    • If it weren't for diminishing returns to scale, supply could expand without limits without increasing the price of a good.
    • If a firm has a production function Q=F(K,L) (that is, the quantity of output (Q) is some function of capital (K) and labor (L)), then if 2Qreturns to scale.
    • Similarly, if 2Q>F(2K,2L), there are increasing returns to scale, and if 2Q=F(2K,2L), there are constant returns to scale.
    • From this production function we can see that this industry has constant returns to scale - that is, the amount of output will increase proportionally to any increase in the amount of inputs.

  • Long Run Supply Decisions

    • This period of supply is known as "increasing returns to scale," because a proportional increase in resources yields a greater proportional increase in output.
    • A long-run supply curve connects the points of constant returns to scales of a markets' short-run supply curves. ; the bottom of each short-term supply curve's "u."
    • In the early stages of the market, where only one or a few firms are producing goods, the market experiences increasing returns to scale, similar to what an individual firm would experience.
    • Eventually the market reaches a state of constant returns to scale.
    • Eventually, production of goods in a market yields less of a return than the amount of goods that go into product, which causes the market to enter into a period of decreasing returns to scale and the market's supply curve slopes upward.

  • Production and Cost in the Long-run

    • The terms "economies of scale," "increasing returns to scale," "constant returns to scale," "decreasing returns to scale" and "diseconomies of scale" are frequently used.
    • Conceptually, returns to scale implies that all inputs are variable.
    • When α+β = 1, the production process demonstrates "constant returns to scale. " If L and K both increased by 10%, output (Q) would also increase by 10%.
    • When α+β < 1, decreasing returns are said to exist.
    • In Figure V.9 economies of scale are said to exist up to output QLC.

  • Marginal Product of Labor (Physical)

    • If a factory that is initially producing 100 widgets hires another employee and is then able to produce 106 widgets, the MPL is simply six.
    • The law of diminishing marginal returns ensures that in most industries, the MPL will eventually be decreasing.
    • The law states that "as units of one input are added (with all other inputs held constant) a point will be reached where the resulting additions to output will begin to decrease; that is marginal product will decline. " The law of diminishing marginal returns applies regardless of whether the production function exhibits increasing, decreasing or constant returns to scale.
    • Under such circumstances diminishing marginal returns are inevitable at some level of production.
    • This table shows hypothetical returns and marginal product of labor.

  • The Law of Diminishing Returns

    • The law of diminishing returns states that adding more of one factor of production will at some point yield lower per-unit returns.
    • If the law of diminishing returns holds, however, the marginal cost curve will eventually slope upward and continue to rise, representing the higher and higher marginal costs associated with additional output.
    • However, as marginal costs increase due to the law of diminishing returns, the marginal cost of production will eventually be higher than the average total cost and the average cost will begin to increase.
    • The typical LRAC curve is also U-shaped but for different reasons: it reflects increasing returns to scale where negatively-sloped, constant returns to scale where horizontal, and decreasing returns (due to increases in factor prices) where positively sloped.
    • Both marginal cost and average cost are U-shaped due to first increasing, and then diminishing, returns.

  • Benefits of Specialization

    • Greater efficiency: Countries specialize in areas that they are naturally good at and also benefit from increasing returns to scale for the production of these goods.
    • They benefit from economies of scale, which means that the average cost of producing the good falls (to a certain point) because more goods are being produced .
    • Opportunities for competitive sectors: Firms gain access to the whole world market, which allows them to grow bigger and to benefit further from economies of scale.
    • Threats to uncompetitive sectors: Some parts of the economy may not be able to compete with cheaper or better imports.
    • This may lead to structural unemployment.

  • Economies of Scale and Network Externalities

    • Economies of scale and network externalities are two types of barrier to entry.
    • Economies of scale are cost advantages that large firms obtain due to their size.They occur because the cost per unit of output decreases with increasing scale, as fixed costs are spread over more units of output .
    • Economies of scale are also gained through bulk-buying of materials with long-term contracts, the increased specialization of managers, ability to obtain lower interest rates when borrowing from banks, access to a greater range of financial instruments, and spreading the cost of marketing over a greater range of output.
    • A natural monopoly arises as a result of economies of scale.
    • Define Economies of Scale., Explain why economies of scale are desirable for monopolies

  • The Relationship Between Risk and Return and the Security Market Line

    • The security market line is useful to determine if an asset being considered for a portfolio offers a reasonable expected return for risk.
    • In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset, taking into account an asset's sensitivity to non-diversifiable or systematic risk.
    • The expected return of an asset is equal to the risk free rate plus the excess return of the market above the risk-free rate, adjusted for the asset's overall sensitivity to market fluctuations or its beta.
    • For individual securities, the security market line (SML) and its relation to expected return and systematic risk (beta) depicts an individual security in relation to their security risk class .
    • The security market line depicts the the return on a security relative to its own risk.