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Increasing Returns To scale in Production

How Increasing Returns to scale in Production can be a basis for trade.
In economics, and returns to scale is a concept that describes what can happen to an economy in
the long run as the scale of production is increased. The returns to scale increases in the light of
the production function of a firm. It describes changes in output that result from proportionate
increase in inputs. When output is increased by the same proportionate change, then constant
returns to scale are realized. If however the output is increased by less than the proportionate
change, then there will be decreasing returns to the scale. The returns to scale seem to be
technologically imposed and do not arise as a result of prevailing market conditions. Under
various levels of output; the production function of a firm can exhibit different returns to scale
(Oz, 2001).
The illustration below is a good example to explain this point:
If inputs are increased by a factor of 2, then the new values for the output become:

• Double the previous output when returns to scale are constant.

• Less than double the previous output when there are decreasing returns to scale and

• Greater than double the previous output when there are increasing returns to scale.

The technology employed in the production of a commodity is said to have increasing returns to
scale if doubling of the resources committed into its production causes output (production) to
more than double. This has the meaning that per unit production cost will be lower when ten
units say are produced than when five units are produced and hence returns to scale arises from
the fact that producing in bulk is cheap in the long run.
Given increasing returns to scale, if for instance the quantities employed for production resources
are tripled, then the production quantity will more than triple. This then means that cost per unit
produced which is also called average cost is a decreasing function of the output. It is worthy
nothing that when there are increasing returns to scale then there can be no perfect competition
as can be shown by the graph below.
 Price

If one assumes all factor costs to be constant, then a firm that experiences constant returns will
have the advantage of constant long-run average costs. On the other hand however, if a firm
experiences decreasing return it will then have increasing long run costs. In order for this
relationship to hold, the firm must a perfect competitor in input market. If in some range of
output there are increasing returns to scale and the firm is stable in the input market such that its
input per unit cost is driven up, then the firm will experience diseconomies of scale if it operates
in that range of output levels (Mishra, 2007).

In economics we normally think of diminishing returns in the short run. In the long run inputs
can be decreased or increased in a proportionate scale. For instance reducing the marginal
productivity of labor can be overcome by an increase in the equipment and tools the workers use

Average cost
in the production process. So in the long run we get the following possible cases:

Loss
Decreasing returns to scale: Here an increase in all inputs by a factor of, say, g results into an
increase in output of a proportion less than g. If for example farm input in a dairy farm increases
price
by twenty per cent and the milk output only increases by fifteen per cent then there is decreasing
returns to scale. This concept is also called diseconomies of scale since production seems to be a
bit cheaper when the scale is quite large.

Constant returns to scale:

This scenario occurs when an increase in inputs in a given proportion q results to an increase in
the output in the same proportion q. Example: if the number of skilled laborers and production
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facilities are increased by twenty five percent and the resulting production level increases by this
same figure, then there is constant return to scale. Increasing returns to scale: This
one occurs when an increase in all inputs in the production process by a certain
factor say q leads to an increase in output by a factor greater than q. This is also
called economies of scale as production is cheaper when the production scale is
quite large.

It is important to note that assumption of returns to scale in production can reveal a

deviation from the presumption of a perfectly competitive market. Almost in all
perfectly competitive market models, it is presumed that production occurs under
constant returns to scale. The implication of this is that the unit costs in production
will remain constant whenever the scale of production is increased. Changing this
assumption can open up the possibilities that strategic behavior positive profits can
be achieved among business firms.

The international trade can be a god example of situations that yield Pareto improvement. That is
a situation where both countries engaged in international trade are better off and none is hurt.
Trying to increase returns to scale can be quite ridiculous as it only allows the output to increase
more than the inputs committed into the production process.
Increasing returns to scale encourages firms to produce enormous amounts of and since the firm
can sell some of the products to other countries, then the real returns to sale are easily achieved
in trade.

Economies of Scale and Returns to Scale

Returns to scale then has it that production in large scale can be achieved at a lower cost. This
can be formalized by presuming that a unit of labor required in the production of a commodity
depends on the level of output produced and hence high output levels are optimal when there is
less commitment of resources and cost. This can be adjusted to show that increasing returns to
scale is equivalent to employing economies of scale in production. Increasing returns to scale has
the meaning that increasing resource consumption increases output by more than the
proportionate increase in the returns to scale.
The other way of characterizing returns to scale by use of a decreasing average cost curve.
Average cost is the quotient of total cost and total output. If average costs decrease with an
increase in output, then it is cheap to produce average units with the rising scale of production
and therefore economies of scale are realized. Returns to scale are mostly found in those
industries which have large fixed production costs. Fixed costs have to be incurred even if
production drops to zero.
Comparative advantage

In economics, comparative advantage is the ability of a firm to produce goods or services at a

lower opportunity cost than its competitors. Comparative advantage shows how trade can result
into more value for two firms even though one firm can produce all its products using fewer
resources than the other. The total net benefits arising from this type of income are called trade
gains.

To understand this logic, let us consider this example. Suppose we have two countries of almost
equal size, A and B. given that both countries produce and consume two basic commodities, X
and Y. the production capability of the two countries is such that when they commit all their
resources to production of commodity X, A produces 100 units while B produces 400 units. And
when the resources are committed to production of commodity Y the production is 100 units for
country A and 200 units for country B. if we assume that each country has a constant opportunity
cost in production of the two products (Brian, 1996).

Assuming that each has constant opportunity costs of production between the two products and
both economies have full employment at all times and that all factors of production are mobile
within the countries between clothes and food industries, but are immobile between the
countries. Then B has got absolute advantages over A with regard to the production of the two
commodities and it seems that there is no mutual benefit for the two countries to trade since
country B is quite efficient in the production of the two commodities (Cobb & Douglas,
2008)

Effects of returns to scale on the economy

The factors that help maximize comparative advantage do not necessarily resolve the deficits
apparent in trade. Almost all real life situations where comparative advantages are attained do
require a trade deficit. For instance, the quantity of a commodity produced can be optimized yet
it might involve transfer of wealth to a foreign country since economic agents do have varying
rates of saving and making investments. As the market undergoes gradual transformation, the
proportion of goods produced by one country compared to another changes but still this
maintains the benefits of comparative advantage. This can result into national currencies
accumulating in foreign bank deposits where a different unit of currency is used. The macro-
economic fiscal policy is normally adapted in addressing the depletion of a national currency
through issuance of more money (Piero, 2006).
The comparative advantage theory holds in line with the industrialization theory on
developmental economics. Both the economic nationalism and the mercantilism have critically
opposed the theory of comparative advantage. The two theories argue that even though a country
can be economically disadvantaged in a certain industry, the country should continue investing in
the industry till it becomes competitive globally. The theories further argue that comparative
advantage is a static theory which does not allow for the possibility of advantages arising from
economic development or venturing in new investments (Piero, 2006).

Some economists however have criticized the comparative advantage theory arguing that this
may have helped all developed c
Countries to maintain advanced technology compared to less developed ones. According to the
principle of comparative advantage, under developed countries which have a comparative
advantage in say mining should continue specializing mining and should import high quality
equipment from developed countries which have a comparative advantage in the production of
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these equipment.

Comparative advantage can be obtained if for instance a capital intensive domestic economy
specializes in the production of one commodity which is exported to a labor intensive foreign
country while the labor intensive foreign economy specializes in the production of another
commodity which is imported by the capital intensive domestic economy. Comparative
advantage is reflected by gains from inter- industry trade whereas economies of scale are and
wider consumer choices are reflected in gains resulting from intra- industry trade. A comparative
advantage in the production of differentiated goods is likely to cause a country to export more of
the commodity than it will import.
Bibliography
Brian, A., 1996, "Increasing Returns and the New World of Business", Harvard Business Review
Cobb, C. W. & Douglas, P. H., 2008, "A Theory of Production", American Economic Review
Mishra, S. K., 2007, A brief history of the Production Function, SSRN Working Paper.
Oz, S., 2001, The Economics of Network Industries, Cambridge University Press.
Piero, S., 2006, "The Laws of Return Under Competitive Conditions", The Economic Journal