Econ 101, Part 8: Microeconomics Deep Dive
Returns to Scale
What happens to output when a firm increases all of its inputs together, and why the answer shapes the size of firms and industries.
The law of diminishing returns describes what happens when a firm increases one input. Returns to scale describe what happens when a firm increases all inputs together, such as doubling both workers and machines.
Three possibilities
- Increasing returns to scale: doubling all inputs more than doubles output. Larger firms become more efficient.
- Constant returns to scale: doubling all inputs exactly doubles output.
- Decreasing returns to scale: doubling all inputs less than doubles output. Very large firms become less efficient.
Why increasing returns occur
- Specialisation: larger firms can divide work into specialised tasks, as Adam Smith described in his pin factory example.
- Large machines: some equipment is only efficient at large scale.
- Spreading fixed costs: research, design and setup costs are spread over more output.
- Network effects in some industries.
Why decreasing returns may occur
- Management difficulties: coordinating very large organisations can become harder.
- Communication problems and bureaucracy.
- Limited resources, such as a finite supply of good land or skilled managers.
Why it matters
Returns to scale help explain industry structure:
- Industries with strong increasing returns, like aircraft manufacturing, steel or software platforms, tend to have a few large firms.
- Industries with constant or decreasing returns, like many restaurants, hair salons and small shops, have many small firms.
They also underpin trade theories. Economist Paul Krugman showed that increasing returns explain why similar countries trade similar goods, such as cars between Germany and Japan, each specialising in particular models to gain scale.
A small bakery doubling its ovens and bakers may roughly double its bread output: constant returns. A large industrial bakery doubling its size may more than double output, using automated lines and bulk purchasing: increasing returns. A giant national bakery chain might struggle to coordinate hundreds of branches, facing decreasing returns in some activities.
Diminishing returns concern adding one input with others fixed. Returns to scale concern increasing all inputs together. A firm can face diminishing returns to labour in the short run but increasing returns to scale in the long run.
- Returns to scale describe what happens when all inputs increase together.
- Returns can be increasing, constant or decreasing.
- Increasing returns come from specialisation, large machines and spreading fixed costs.
- Returns to scale shape industry structure and help explain trade between similar countries.
No recording for this one yet - EconReader can read it aloud for you.