Returns to scale
The
concept of returns to scale explains the change in output due to change in
inputs.
Increasing returns to scale: increasing
returns to scale occurs when it brings a more than proportionate change in
output compared to change in its inputs. For an example, an increase in input
by 20% leads to an increase in output by 30%.
Consider
the following example.
|
|
Input
|
Output
|
|
Year
1
|
70
|
10,000
|
|
Year
2
|
120
|
25,000
|
The
input (factors of production) in the second year has been increased from 70 to
120 (an increase of 71%). This has increased the output from 10,000 to 25,000
units, which is an increase of 150%. Hence, there is an increasing returns to
scale as the change in output is more than the change in input.
Decreasing returns to scale: decreasing
returns to scale occurs when it brings a less proportionate change in output
compared to change in its inputs. For an example, an increase in input by 20%
leads to an increase in output by 15%.
|
|
Input
|
Output
|
|
Year
1
|
55
|
12000
|
|
Year
2
|
110
|
20000
|
The
above example shows decreasing returns to scale. An increase in input from 55
to 110 (an increase of 100%) increased the output from 12,000 to 20,000, which
is an increase of 67%.
Constant returns to scale: constant
returns to scale occur when the change in input brings an equal change in its
output. For an example, an increase in input by 50% leads to an increase in
output by 50%.
|
|
Input
|
Output
|
|
Year
1
|
65
|
9,000
|
|
Year
2
|
130
|
18,000
|
The
above example shows constant returns to scale. An increase in input from 65 to
130 (an increase of 100%) increased the output from 9,000 to 18,000, which is
also an increase of 100%.
Economies of scale
Economies of
scale refer to a fall in the long run average cost of a firm due to expansion
in its scale of production. A firm enjoys economies of scale when the
percentage increases in its output is greater than the percentage increase in
its input.
 |
The diagram
shows that the firm enjoys economies of scale till output 120. Firm’s average
cost goes on declining until 120 units. Between 120 to 220 units, the firm is
having constant returns to scale, that is average cost remains same between
these range of output. However, when the firm increases its output more than
220, the firm’s Average cost starts to increase showing diseconomies of scale. Diseconomies
of scale occur when the firm’s long run average cost increases as it increase
it output.
Economies of
scale can be classified as two:
-
Internal economies of scale
-
External economies of scale
Internal
economies of scale
Internal
economies of scale refer to the advantages enjoyed by the firm individually in
the form of reduced average cost, due to the expansion of its scale of
production. A large firm’s total cost is higher than that of small firms, but
its average would be lower than that of a small firm. This is due to the
different types of internal economies the large firm is able to enjoy due to
expansion of its scale of production.
Types of
Internal Economies of Scale
Technical
economies: cost savings caused by the methods of production used.
§
Large firms can make more use of division of
labour, which would increase the output thereby reducing the average cost
§
Large firms can make more effective use of large
units of machinery. These machineries can be operated at low average cost when
they are used to their full capacity by large firms.
§
Large firms ill have the resources to maintain a
research and development department to help improve the quality of its products
and introduce new methods of production.
Marketing
economies: cost saving resulting from the way in which firms sell their
products.
§
A large firm has enough working capital – they
can place large orders with their suppliers to buy the materials in bulk
quantities, and able to get preferential treatment by getting resources at
lower prices.
§
A large firm will be able to employ specialist
workers – they can employ specialist salesmen to maintain and expand in its
markets, and specialist buyers to ensure that it obtains good quality and
low-cost supplies of raw materials.
§
Handling and packaging costs are very low – in
large firm as the cost would be divided among a large quantity of output. So
the cost per unit of output will be very low. Therefore large firms can sell
their products at low prices.
§
Advertising cost per unit is very low – as large
firms’ output is greater than small firms so the advertising cost per unit sold
is likely to be much less than that of a small firm. Therefore, the large firms
can spend more on advertisement to increase its demand.
Financial
economies: cost saving that arises from the way in which large firms raise
money.
§
As the large firms have more valuable assets and
are better known than the small firms, lenders believe that there is less risk
in making a loan to the large firms. Therefore, the large firms can obtain
finance more cheaply and easily than small firms.
§
They have more sources of finance, e.g. raise
money by selling shares thorough the stock exchange.
Risk-bearing
economies: cost savings that result from the way in which firms try to
reduce the risk of fall in demand for some of their products.
§
Large firm scan avoid risk through
diversification. Diversification means producing a wide variety of products to
increase security. Even if one product’s demand decreases the firm would still
have other products to depend on.
Managerial
economies: large firms can employ the most professional managers who are
attracted by high salaries, prestige and power of responsible positions in a
large firm. The employment of specialist mangers in charge of purchase,
administration, sales, accounts etc … brings the advantage of division of
labour, including increased efficiency of the firm.
External Economies of Scale
External economies of scale arise when
there is a growth in the size of the industry and are available for many firms
in it.
1. Economies related to a particular
industry. They are derived from the concentration of the industry in one
place and differ between industries. They might involve cheaper training
facilities if many firms want to train their employers or marketing economies
when several firms want the same kind of raw material. They can be realized
through trade associations which are producers' unions, which can e.g.
advertise the industry generally, thus raising the revenue of all the firms
included.
2. Economies related to industrialization.
If there is a great concentration in specific place, e.g. many people come to
look for job there. Usually the communication expenses (maintenance of roads)
can be shared. The activities of the essential services sector multiply,
providing more advantages to firms in the industrialized area.
3. Economies related to society.
The provision of roads, schools etc. is largely the responsibility of the
state. As industrialization increases the provision of these items increases
giving further advantages to firms in the area.