Lecture 07 returns to scale
Download as PPT, PDF1 like735 views
The document discusses the law of returns to scale, which analyzes how output changes in response to simultaneous changes in all inputs. It outlines three types of returns to scale: increasing, constant, and decreasing, along with their characteristics and causes. Additionally, it differentiates the laws of returns to scale from the law of variable proportions, emphasizing their applicability over different time periods.
Lecture 07 returns to scale
- 1. Lecture 07: Returns to Scale 1
- 2. Law of returns to scale • The laws of returns to scale explain the behavior of output in response to a proportional and simultaneous change in all the inputs. • Assumption: All the inputs change in same proportions. 2
- 3. 3
- 4. Concept: 4/23/2020 4 P = f (L, K) Suppose the production function is as follows: Now, if both the factors of production i.e., labour and capital are increased in same proportion i.e., x, product function will be rewritten as:
- 5. Assumptions • All the factors of production (such as land, labor and capital) but organization are variable • The law assumes constant technological state. It means that there is no change in technology during the time considered • The market is perfectly competitive • Outputs or returns are measured in physical terms. 5
- 6. Types of Returns to Scale When a firm increases all the inputs in the same proportion, then there are three possibilities: 1. Total output may increase more than proportionately 2. Total output may increase proportionately 3. Total output may increase less than proportionately Accordingly, there are three kinds of return to scale 1. Increasing returns to scale 2. Constant returns To Scale 3. Decreasing returns to scale 6
- 7. Unit Scale of Production Total Returns Marginal Returns Stage 1 1 Labor + 2 Acres of Land 4 4 (Stage I - Increasing Returns) 2 2 Labor + 4 Acres of Land 10 6 3 3 Labor + 6 Acres of Land 18 8 4 4 Labor + 8 Acres of Land 28 10 (Stage II - Constant Returns) 5 5 Labor + 10 Acres of Land 38 10 6 6 Labor + 12 Acres of Land 48 10 7 7 Labor + 14 Acres of Land 56 8 (Stage III - Decreasing Returns) 8 8 Labor + 16 Acres of Land 62 6 A hypothetical example of returns to scale: 7
- 8. 8 Returns to Scale: Diagrammatic representation
- 9. I Stage: Increasing returns to scale • The firms are faced with increasing returns to scale when a certain proportionate change in inputs, lead to more than proportionate change in output. Causes: 1. Division of labour 2. Higher degree of specialization 3. External economies of scale 9 Note: Economies of scale are the cost advantages that enterprises obtain due to their scale of operation, with cost per unit of output decreasing with increasing scale. E.g. Think of a hotel business more the customers, lesser will be per unit operating cost.
- 10. II Stage: Constant returns to scale: • When the change in output is proportional to the change in inputs, it exhibits constant returns to scale. # Changes in output and input are same. • Economies of scale is balanced by diseconomies of scale. • This is also known as homogeneous production function. 10 Diseconomies of scale represent the situation where the marginal cost or long run average cost per unit of output produced increases with increase in production due to internal and external factors.
- 11. Decreasing returns to scale: • The firms are faced with decreasing returns to scale when a certain proportionate change in inputs, lead to less than proportionate change in output. • It means, if inputs are doubled, output will be less than doubled. • If 20 percent increase in labour and capital is followed by 10 percent increase in output, then it is an instance of diminishing returns to scale. 11
- 12. Causes of Diminishing return to scale 12 • Limited resources • Decrease in managerial efficiency (as firm size expands)
- 13. Difference between the law of Returns and Law of Returns to Scale Law of Variable Proportions • Applicable in short period • Only one factor is varied • The factor ratio remains changed • There are three stages: a) Increasing returns to a factor b) Decreasing returns to a factor c) Constant returns to a factor Returns to Scale • Applicable in long period • All factors varied • The factor ratio remains unchanged • There are three stages: a) Increasing returns to scale b) Decreasing returns to scale c) Constant returns to scale 13