Returns to scale
From Freepedia
In economics, returns to scale and economies of scale are terms that are related, and sometimes incorrectly used interchangeably. They describe what happens as the scale of production increases.
Contents |
Returns to scale
Returns to scale refers to a technical property of production: what happens to output if we increase the quantity of all input factors by some amount. If output increases by that same amount there are constant returns to scale (CRS). If output increases by less than that amount, there are decreasing returns to scale. If output increases by more than that amount, there are increasing returns to scale, sometimes referred to simply as returns to scale.
Economies of scale
Economies and diseconomies of scale refer to an economic property of production: what happens to cost if we increase the quantity of all input factors by some amount. If costs increase proportionately, there are no economies of scale, if costs increase by a greater amount, there are diseconomies of scale, if costs increase by a lesser amount, there are (positive) economies of scale. When combined, economies of scale and diseconomies of scale lead to ideal firm size theory, which states that per-unit costs decrease until they reach a certain minimum, then increase as the firm size increases further.
Economies of scale tend to occur in industries with high capital costs in which those costs can be distributed across a large number of units of production (both in absolute terms, and, especially, relative to the size of the market).
The exploitation of economies of scale helps explain why companies grow large in some industries. It is also a justification for free trade policies, since some economies of scale may require a larger market than is possible within a particular country - for example, it would not be efficient for Liechtenstein to have its own car maker, if they would only sell to their local market. A lone car maker may be profitable, however, if they export cars to global markets in addition to selling to the local market. Economies of scale also play a role in a natural monopoly.
Typically, because there are fixed costs of production, economies of scale are initially increasing, and as volume of production increases, eventually diminishing, which produces the standard U-shaped cost curve of economic theory. In some economic theory (eg perfect competition) there is an assumption of constant returns to scale.
Network Effect
Network externalities resemble economies of scale, but they are not considered such because they are a function of the number of users of a good or service in an industry, not of the production efficiency within a business. Economies of scale external to the firm (or industry wide scale economies) are only considered examples of network externalities if they are driven by demand side economies.
Formal definitions
Formally, a production function <math>F(K,L)</math> is defined to have constant returns to scale if <math>F(aK,aL)=aF(K,L) </math>, increasing returns to scale if <math>F(aK,aL)>aF(K,L), </math> and decreasing returns to scale if <math>F(aK,aL)<aF(K,L) </math>, where K and L are some factors of production, possibly capital and labor, respectively.
As an example, the Cobb-Douglas functional form has constant returns to scale: the function itself is <math>F(K,L)=AK^{b}L^{1-b}</math>, where A > 0 and 0 < b < 1. Now <math>F(aK,aL)=A(aK)^{b}(aL)^{1-b}=Aa^{b}a^{1-b}K^{b}L^{1-b}=aAK^{b}L^{1-b}=aF(K,L)</math>
See also
- diseconomies of scale
- ideal firm size
- microeconomics
- production, costs, and pricing
- economies of scope
- economies of agglomeration
- Mohring effect
- experience curve effects
