Returns to Scale

Question 1

Returns to Scale describe the Effects of Increasing the Scale of Production

Answer 1

In the long run firms can increase all of their factor inputs. Returns to scale describe the effect on output of increasing all factor inputs by the same proportion.

1. Increasing Returns to Scale:
   - There are increasing returns to scale when an increase in all factors inputs leads to a more than proportional increase in output. E.g. doubling all of the factor inputs results in a tripling of output.
2. Constant Returns to Scale:
   - There are constant returns to scale when an increase in all factor inputs leads to a proportional increase in output. E.g. doubling all the factor inputs results in a doubling of output
3. Decreasing returns to scale:
   - There are decreasing returns to scale when an increase in all factor inputs => less than proportional increase in output. E.g. tripling all the factor inputs results in a doubling of output.

Question 2

Increasing Returns to Scale contribute to Economies of Scale

Answer 2

1. Returns to scale and economies of scale are not the same thing.
   - Returns to scale describe how much output changes as input is increased,
   - Economies of scale descrive reductions in average costs as output is increased.
2. However, there is a link between the two ideas:
   - Increasing returns to scale contribute to economies of scale,
   - Decreasing returns to scale contribute to diseconomies of scale
3. When returns to scale are increasing, long run average cost will fall. An increase in input => more than proportional increase in output, so more output is being produced per unit of input.
4. When returns to scale are constant, long run average cost will stay the same - costs are increasing proportionally to output.
5. When returns to scale are decreasing, long run average cost will rise. Less output is being produced per unit of input.
   * LOOK AT DIAGRAM ON PAGE 47*

Question 3

Long Run Average Costs are Minimised at the MES

Answer 3

• The minimum efficient scale of production is the lowest level of output at which the minimum possible average cost can be achieved - it’s the first point at which the LRAC curve reaches its minimum value. This is likely to be the optimal level of production.
• There might be a range of production levels where the LRAC is minimised, or the MES might be the only LRAC minimising level.
• The MES varies between industries - industries with very high fixed costs have a very large MES. This affects the whole structure of an industry - industries with a large MES will favour large firms more.
• LOOK AT DIAGRAM ON PAGE 47*