Dominick Salvatore Schaums Outline of Microeconomics, 4th edition Schaums Outline Series 2006

CHAP. 6] THEORY OF PRODUCTION 143
RETURNS TO SCALE
6.24 Explain what is meant by (a) constant returns to scale, (b) increasing returns to scale, and (c) decreasing
returns to scale. Explain briefly how each of these might arise.
(a)
(b)
(c)
Constant returns to scale means that if all factors of production are increased in a given proportion, the output
produced would increase in exactly the same proportion. Thus, if the quantities of labor and capital used per
unit of time are both increased by 10%, output increases by 10% also; if labor and capital are doubled, output
doubles. This makes sense; if we use two workers of the same type and two identical machines, we normally
expect twice as much output as with one worker with one machine. Similarly, if all inputs are reduced by a
given proportion, output is reduced by the same proportion.
Increasing returns to scale refers to the case when all factors are increased in a given proportion, output
increases in a greater proportion. Thus if labor and capital are increased by 10%, output rises by more
than 10%; if labor and captial are doubled, output more than doubles. Increasing returns to scale may
occur because by increasing the scale of operation, greater division of labor and specialization becomes possible.
That is, each worker can specialize in performing a simple repetitive task rather than many different tasks.
As a result, labor productivity increases. In addition, a larger scale of operation may permit the use of more
productive specialized machinery which was not feasible at a lower scale of operation.
If output increases in a smaller proportion than the increase in all inputs there are decreasing returns to scale.
This may result because as the scale of operation increases, communications difficulties may make it more and
more difficult for the entrepreneur to run a business effectively. It is generally believed that at very small scales
of operation, the firm faces increasing returns to scale. As the scale of operation rises, increasing returns to
scale give way to constant returns to scale and eventually to decreasing returns to scale. Whether this is
the case in a particular situation is an empirical question.
6.25 Which set of isoquants in Fig. 6-24 shows (a) constant returns to scale, (b) increasing returns to scale,
and (c) decreasing returns to scale?
Fig. 6-24
(a)
(b)
Panel B shows constant returns to scale. It shows that when we double both inputs, we double output; if we
triple all inputs, we triple the level of output. Thus, OG ¼ GH ¼ HJ (and similarly for any other ray from the
origin). Note that output expands along ray OE (and the K/L ratio remains unchanged), as long as relative
factor prices remain unchanged. (Compare panel B with panel A of Fig. 6-23, where the K/L ratio was
technologically fixed.)
The case of increasing returns to scale is shown in panel A, where an increase in both inputs in a given proportion
causes a more than proportionate increase in output. Thus, OM . MN . NR. Once again, if relative
factor prices remain unchanged, output expands along ray OD.