Returns to scale
In economics, returns to scale describe the relationship between the size of a firm (or a production unit) and its long run average costs per unit. Typically, returns to 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.
An alternative terminology is economies of scale for increasing returns to scale, and diseconomies of scale for decreasing returns to scale. Being shorter this is often more convenient.
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Economies of scale
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. Economies of scale also play a role in natural monopoly.
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) 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>
Categories: Microeconomics | The economics of production See also
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