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Returns to Scale
It is a major concern in economics to check the output levels due to changes in inputs. As is notable, there may be changes of various amounts in inputs, such as changes in one factor or changes in all factors. Moreover, these changes in inputs may be proportional or random. Depending on the rate of change of inputs various types of returns to scale can be achieved.
Returns to Scale
Returns to scale is the rate of change of output when all inputs are changed by the same factor.
In other words, returns to scale is the rate of change that occurs due to a proportional change in all inputs. The rate of change of outputs is a measure of returns to scale as it shows the production levels. Therefore, returns to scale is a term related to the production of goods and services.
We will see later in this tutorial, the output rate may remain the same, increase or decrease for proportional change of inputs. Therefore, we may assume that returns to scale is a concept that just tells about the rate of change in the cases of increase, decrease, or no change in the levels of output.
When we consider the rate of change in output, there are some interesting facts that are notable. One among them is that the rate of production may not increase or even go down even when inputs are increased in the production process. Such outcomes are usually available because the production of goods does not actually adhere to amounts of inputs.
Rather, the output follows a norm in which there is a critical point crossing which may result in a decrease in outputs. Similarly, in some other instances, the production may remain unchanged even when inputs are added increasingly too.
Constant Returns to Scale (CRS)
When the rate of change of outputs is equal to the rate of increase of inputs, the returns are said to be constant and the process is said to show a behavior of constant returns to scale (CRS).
In the case of CRS, with the increasing addition of inputs, the outputs increase proportionally. That means when the inputs are changed by a certain proportion, the outputs also increase in that given proportion.
The phenomenon of CRS is generally seen in the middle stages of the production process. In this stage, any increase in the inputs results in a direct increment of outputs at the same rate. This means that producers can take advantage of this stage to produce more goods by increasing the inputs. As outputs increase at the same rate, producers can realize how much input is required to get a certain amount of output in order to increase the production of goods.
However, the condition of CRS is not manageable forever. With the advancement of the production process, and the addition of more inputs, the process may attain levels of Increased returns to scale or decreasing returns to scale. Let us see these two in detail below.
Increasing Returns to Scale (IRS)
In general, in the initial stages of production, the additional rate of inputs results in a higher rate of return of outputs. This outcome is termed increasing returns to scale (IRS).
In the case of IRS, the outputs are therefore higher than the net inputs in the process.
In the IRS stage, the addition of input, at any rate, would result in the creation of outputs at a higher rate. Therefore, producers can take advantage of this stage to create more goods. When the demand is high, producers need to be in this segment of production to get maximum benefits.
Like all other stages of production, the IRS stage also cannot be maintained forever. With the addition of more inputs and advancement in the production process, the IRS stage is lost and the increased rate of output can no longer be managed by the producers.
Decreasing Returns to Scale (DRS)
Decreasing returns to scale is the opposite of IRS where the increasing amount of inputs leads to a negative amount of outputs.
In this final stage of production, any addition in production stages cannot produce goods at the rate of additional inputs or at an enhanced rate. Instead, the number of outputs is obtained at a lower rate when the production process reaches this stage.
It is notable that the production of goods does not get stalled in this stage of production but the rate at which outputs were obtained in IRS and CRS cannot be repeated in this stage. DRS is often the final stage of production, but it can be a disadvantageous form for the producers when demand for their products is high.
Law of Diminishing Marginal Returns
The law of diminishing marginal returns states that after some optimal level of capacity is reached, additional factors of production would result in smaller increases in output. The factors of production are labor, land, capital, and entrepreneurship. So, for example, if an increasing amount of land is used for the production of crops, after an optimal stage, the rate of production of crops would actually go down.
It must be noted that the law of diminishing marginal returns assumes that there is a change in only one factor of production while other factors remain unchanged. It is an important law because otherwise, a layman would consider that increasing factors of production infinitely would let him achieve infinite productivity, which is impossible in the real world.
Returns to scale is an important concept in economics. It shows the relationship between inputs and outputs in a production process which is crucial because any imbalance in production would mean that supply is affected negatively. Producers can use the concept of returns to scale to adjust the productions.
However, it must be noted that it is important to realize the stage of production in order to use the theory productively.
For example, an organization that is in the IRS stage can produce more whereas if the company is in the DRS stage, the organization would produce less of the products.
Returns to scale can also be a significant factor in evaluating the efficiency of production of an organization. Knowing the production levels and comparing them with the required productions that should be achieved in a certain stage, producers can compare the productivity of a production process. This may help producers evaluate the efficiency of production and can let the companies aim for a certain rate of growth.
These advantages make the concept of returns to scale a cherished concept in economics that is the backbone of the evaluation of the production.
Q1. What are the three types of returns to scale and what are the differences among them?
Ans. The three types of returns to scale are constant returns to scale (CRS), increasing returns to scale (IRS), and decreasing returns to scale (DRS). Constant returns to scale occurs when the rate of change of the output is equal to proportionate change in inputs, increasing returns to scale (IRS) occurs when rate of change of the output is more than proportionate change in inputs, and decreasing returns to scale (DRS) occurs when the rate of change of the output is less than proportionate change in inputs.
Q2. Which stage of returns to scale is most advantageous to producers?
Ans. Increasing returns to scale (IRS) is most advantageous because it shows more productivity.
Q3. What does decreasing returns to scale mean in short?
Ans. In short, decreasing returns to scale refers to production that shows a lack of increase or equality in outputs in comparison to the rate of inputs.
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