In the long run with all the inputs variable, the firm must also consider the best way to increase output. One way to do so is to change the scale of operation by increasing all of the inputs to production in proportion. For example if it takes one man and one machine to produce 50 pieces of masks everyday, what will happen if we employ 2 men along with 2 machines? Output will most certainly increase but we do not know for sure if it will exactly double, more than or less than double. Returns to scale basically is the rate at which output increases as inputs are increased proportionately.

Returns to Scale can be of 3 types –

1. Increasing Returns to Scale
2. Constant Returns to Scale
3. Decreasing Returns to Scale

Increasing Returns to Scale (IRS) : When inputs are doubled if outputs are more than doubled then there are increasing returns to scale. This may arise as larger scale of operations let managers and labours to specialize in their tasks and to make use of more sophisticated, large sale factories and equipment. The automobile assembly line is a good example of increasing returns.

If there are increasing returns then it is economically advantageous to have one large firm producing at relatively lower cost than having many small firms at relatively higher cost. As the large firms can control the price it sets, it may need to be regulated as well. For example, increasing returns in provision of electricity is one reason we have large regulated power companies. Let’s see a diagrammatic representation of IRS below-

In the above diagram the 45 degree line from the origin describes a production process in which labour hours and machine hours are used as inputs to produce various levels of output in the ratio of 5 hours of labour to 2 hours of machine time. Here, the firm’s production function exhibits increasing returns to scale. The isoquants come closer together as we move away from the origin. As a result, less than twice the amount of both inputs is needed to increase production from 10 units to 20 and substantially less than 3 times input to produce 30 units.

Constant Returns to Scale (CRS) : A second possibility is that the output may double when inputs are also doubled. With CRS, the size of the firm’s operation does not affect the productivity of its factors. For example, a large beauty salon can provide the same service per client and use the same capital (products or salon space) and labour as a small salon which caters to fewer clients.

From the above diagram it can be seen that 5 hours of labour and 2 hours of machine time produce 10 units of output. When both inputs are doubled, outputs are doubled from 10 to 20 units and both inputs are tripled output is tripled from 10 to 30 units.

Decreasing Returns to Scale (DRS) : Finally, output may also less than double when all inputs are doubled. This case of decreasing returns to scale applies to some firms with large scale operations. Difficulties in organizing and running a large scale operation may lead to decreased productivity of both labour and capital.

In the above diagram the firm’s production function exhibits decreasing returns to scale. The distance between the isoquants as we move away from the origin increases gradually. More than twice the amount of both inputs are needed to increase production from 10 to 20 units.