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WHAT IS INCREASING RETURNS TO SCALE AND WHY DOES A FIRM EXPERIENCE IT?

Updated on March 3, 2011

Increasing returns to scale is a long run phenomenon. The long run by definition is the period long enough for the inputs of all factors of production to be varied, but not so long that the basic technology of production changes. In the long run, all inputs are variable and changes in output are attributed to changes in all the inputs. In such a situation, we say the plant scale or plant size is varied. The resultant returns to output are due to the plant scale. These returns are referred to as the laws of returns to scale and they are increasing returns to scale, constant returns to scale and decreasing returns to scale. Returns to the factor (as explained earlier in one of my articles), is a short run phenomenon but returns to scale is of the long run. This article focuses attention on increasing returns to scale.

When a firm increases its plant size by increasing its inputs and experiences a situation where the percentage increase in the output exceeds the percentage increase in all the inputs then the firm is said to experience increasing returns to scale. Under such circumstance, the firm adds more to output than to cost.

WHY WE HAVE INCREASING RETURNS TO SCALE

When firms expand their plant size or scale of production, they enjoy certain advantages. Increasing returns to scale is the result of these advantages which are called internal economies of scale. Internal economies of scale are of five main kinds which are explained below:

Technical Economies

As a firm grows in size and produces greater level of output, it can afford to employ larger machines and equipment which can be used to produce more output than smaller machines. For example a bigger tractor could be employed instead of a smaller one. To make maximum use of the larger machine, the scale of production must be increased. If the machine is used to produce on a small scale, the cost of operating the machine will be the same as when it is used for large scale production, and increases the average cost of production. If therefore large machines are used to produce on a large scale, the average cost is reduced. Average cost is total cost divided by the output produced.

Managerial Economies

When output increases, division of labor can be applied to management. For example in a shop owned and run by one man, the same person may order supplies, keep accounts and sell the goods and yet has to do the trivial jobs as sweeping the floor, weighing articles and packing parcels. These tasks could easily be done by a lower-paid employee. The large business overcomes this difficulty by employing a competent organizer who can organize the routine jobs and give them to lower-paid workers. The function of management itself can be divided example into production, sales, transport and personnel. Indeed, optimum use of management reduces cost. This is because management need not increase proportionately with an increase in output. In other words we don’t necessarily have to engage more managers for output to increase.

As a firm expands, mechanization of the management function becomes possible through the use of modern equipment and gadgets that result in saving of time and increase in output.

Marketing Economies

Indeed, large firms often manufacture many products so that one acts as advertisement for others. A large firm may be able to sell its by-products, something which might be unprofitable for a small firm due to their small level of production. When the business is sufficiently large, division of labor can be introduced on the commercial side with expert buyers and sellers being employed. Large firms existing in the long run can afford to buy raw materials in bulk as they expand. This makes it possible for them to enjoy discounts. Advertising economies are also enjoyed. This is because cost of advertising need not increase with output. The resultant effect of the above is a fall in the long-run average cost as a result of increasing returns to scale.

Financial Economies

In raising finance for expansion, the large firm is in a favorable position. It can for instance offer better security to bankers and, because it is well known, it can get loans from bank at lower interest rates. This leads to a fall in the long-run average cost of production and therefore the firm adds more to output than to cost i.e. increasing returns to scale.

Risk-bearing Economies

Large firms are better equipped to bear risks of trading than small firms. To meet changes in demand, the firm can produce more than one product so that a fall in demand for any of them can be offset by a rise in demand for the other products. A large firm is likely to have many markets for its products. A fall in demand in the home market might be balanced by a rise in demand oversees.

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