LAW OF RETURNS TO SCALE

Production Function with two variable inputs

Before knowing what the law of returns to scale states, it is pertinent to gain some knowledge
on the production function. The production function is a highly abstract concept that has been
developed to deal with the technological aspects of the theory of production. A production
function is an equation, table or graph, which specifies the maximum quantity of output, which
can be obtained, with each set of inputs. An input is any good or service that goes into
production, and an output is any good or service that comes out of the production process. Prof.
Richard H. Leftwich attributes that production function refers to the relationship between
inputs and outputs at a given period. Here inputs mean all the resources such as land, labour,
capital and organization used by a firm, and outputs mean any goods or services produced by
the firm.
Suppose we want to produce apples. We need land, water, fertilizers, workers and some
machinery. These are called inputs or factors of production. The output is apples. In abstract
terms, it is written as Q = F(X
1
, X
2
X
n
). Where Q is the maximum quantity of output and X
1
, X
2
,
X
n
are the quantities of the various inputs. If there are only two inputs, labour L and capital K,
we write the equation as Q = F(L,K).
According to Cobb-Douglas, Production Function is as follows:

Now as Q = aL
b
K
c

Log
10
Q = a + bLog
10
L + cLog
10
K

1. If b+c > 1, Increasing Returns to Scale
2. If b+c = 1, Constant Returns to Scale
3. If b+c < 1, Diminishing Returns to Scale

From the above equation, we can understand that the production function tells us the
relationship between various inputs and outputs. However, it does not say anything about the
combination of inputs. The optimal combination of inputs can be derived from the technique of
isoquant and isocost line.
The concept of production function stems from the following two things:
1. It must be considered with reference to a particular period.
2. It is determined by the state of technology. Any change in technology may alter output, even
when the quantities of inputs remain fixed.

Law of Returns to Scale
In the long- run the dichotomy between fixed factor and variable factor ceases. In other words,
in the long-run all factors are variable. The law of returns to scale examines the relationship
between output and the scale of inputs in the long-run when all the inputs are increased in the
same proportion.
Assumptions
This law is based on the following assumptions:
1. All the factors of production (such as land, labour and capital) but organization are variable
2. The law assumes constant technological state. It means that there is no change in
technology during the time considered.
3. The market is perfectly competitive.
4. Outputs or returns are measured in physical terms.
Three phases of returns to scale
There are three phases of returns in the long-run which may be separately described as (1) the
law of increasing returns (2) the law of constant returns and (3) the law of decreasing returns.
Depending on whether the proportionate change in output equals, exceeds, or falls short of the
proportionate change in both the inputs, a production function is classified as showing constant,
increasing or decreasing returns to scale.
Let us take a numerical example to explain the behavior of the law of returns to scale.
Table 1: Returns to Scale
Unit
Scale of
Production
Total Returns Marginal Returns
1
1 Labour + 2 Acres
of Land
4
4 (Stage I -
Increasing Returns)
2
2 Labour + 4 Acres
of Land
10 6
3
3 Labour + 6 Acres
of Land
18 8
4
4 Labour + 8 Acres
of Land
28
10 (Stage II -
Constant Returns)
5
5 Labour + 10
Acres of Land
38 10
6
6 Labour + 12
Acres of Land
48 10
7
7 Labour + 14
Acres of Land
56
8 (Stage III -
Decreasing
Returns)
8 8 Labour + 16 62 6
Unit
Scale of
Production
Total Returns Marginal Returns
Acres of Land

The data of table 1 can be represented in the form of figure 1

RS = Returns to scale curve
RP = Segment; increasing returns to scale
PQ = segment; constant returns to scale
QS = segment; decreasing returns to scale

Increasing Returns to Scale
In figure 1, stage I represents increasing returns to scale. During this stage, the firm enjoys
various internal and external economies such as dimensional economies, economies flowing
from indivisibility, economies of specialization, technical economies, managerial economies and
marketing economies. Economies simply mean advantages for the firm. Due to these
economies, the firm realizes increasing returns to scale. Marshall explains increasing returns in
terms of increased efficiency of labour and capital in the improved organization with the
expanding scale of output and employment factor unit. It is referred to as the economy of
organization in the earlier stages of production.


Constant Returns to Scale
In figure 1, the stage II represents constant returns to scale. During this stage, the economies
accrued during the first stage start vanishing and diseconomies arise. Diseconomies refers to the
limiting factors for the firms expansion. Emergence of diseconomies is a natural process when a
firm expands beyond certain stage. In the stage II, the economies and diseconomies of scale are
exactly in balance over a particular range of output. When a firm is at constant returns to scale,
an increase in all inputs leads to a proportionate increase in output but to an extent.
A production function showing constant returns to scale is often called linear and
homogeneous or homogeneous of the first degree. For example, the Cobb-Douglas production
function is a linear and homogeneous production function.

Diminishing Returns to Scale
In figure 1, the stage III represents diminishing returns or decreasing returns. This situation
arises when a firm expands its operation even after the point of constant returns. Decreasing
returns mean that increase in the total output is not proportionate according to the increase in
the input. Because of this, the marginal output starts decreasing (see table 1). Important factors
that determine diminishing returns are managerial inefficiency and technical constraints.














PRODUCTION FUNCTION
BRITANNIA

The Sales (Production),Labour (Compensation of Employees), Capital (Capital) data for Britannia
Industries for the years 1988-2013 is listed below.

YEAR SALES
COMPENSATION
OF EMPLOYEES CAPITAL
log10
SALES
log10
COMPENSATION
OF EMPLOYEES
log10
CAPITAL
AVERAGE
PRODUCTI
VITY
MARGINAL
PRODUCTI
VITY
1988 3580 365.8 123.8 3.554 2.563 2.093 9.787 0.000
1989 3185 294.3 185.7 3.503 2.469 2.269 10.822 5.524
1990 3650.7 337.6 185.7 3.562 2.528 2.269 10.814 10.755
1991 4319.2 379.4 185.7 3.635 2.579 2.269 11.384 15.993
1992 4478.5 412.5 185.7 3.651 2.615 2.269 10.857 4.813
1993 4801.3 452.7 185.7 3.681 2.656 2.269 10.606 8.030
1994 5655.8 508 185.7 3.752 2.706 2.269 11.133 15.452
1995 6591.6 586.3 185.7 3.819 2.768 2.269 11.243 11.951
1996 8203.6 683.6 185.7 3.914 2.835 2.269 12.001 16.567
1997 8478.4 725.7 185.7 3.928 2.861 2.269 11.683 6.527
1998 10301.4 829.1 185.7 4.013 2.919 2.269 12.425 17.631
1999 11698.4 924 278.5 4.068 2.966 2.445 12.661 14.721
2000 13325.2 993.5 278.5 4.125 2.997 2.445 13.412 23.407
2001 14509.8 997.4 278.5 4.162 2.999 2.445 14.548 303.744
2002 13490.5 973.2 278.5 4.130 2.988 2.445 13.862 42.120
2003 14705.3 961.2 310.9 4.167 2.983 2.493 15.299 101.233
2004 16154.5 872.9 310.9 4.208 2.941 2.493 18.507 16.412
2005 18179.2 865.5 310.9 4.260 2.937 2.493 21.004 273.608
2006 23830.7 888 310.9 4.377 2.948 2.493 26.836 251.178
2007 26169.8 1057.2 310.9 4.418 3.024 2.493 24.754 13.824
2008 32241.8 1240.3 310.9 4.508 3.094 2.493 25.995 33.162
2009 34783.7 1323.8 310.9 4.541 3.122 2.493 26.276 30.442
2010 43059 1199.3 310.9 4.634 3.079 2.493 35.903 66.468
2011 50255.9 1458.7 310.9 4.701 3.164 2.493 34.453 27.744
2012 56979.2 1435 310.9 4.756 3.157 2.493 39.707 283.684
2013 62321.1 1724.5 310.9 4.795 3.237 2.493 36.139 18.452





REGRESSION ANALYSIS FOR BRITANNIA INDUSTRIES


SUMMARY OUTPUT


Regression Statistics

Multiple R 0.963

R Square 0.927

Adjusted R Square 0.921

Standard Error 0.112

Observations 26.000


ANOVA


df SS MS F
Significance
F

Regression 2 3.665 1.832
146.99
6 0.000

Residual 23 0.287 0.012

Total 25 3.951



Coefficient
s
Standard
Error t Stat P-value Lower 95%
Lower
95.0%
Upper
95.0%
Intercept -1.624 0.466
-
3.488 0.002 -2.587 -2.587 -0.661
log10COMPENSATIO
N OF EMPLOYEES 1.466 0.195 7.517 0.000 1.063 1.063 1.870
log10CAPITAL 0.628 0.350 1.794 0.086 -0.096 -0.096 1.352

Interpretation
Interpreting the regression formula, we get the following equation:

Log
10
Q = -1.624 + 1.466Log
10
L + 0.628Log
10
K

Here, a = -1.624
b = 1.466
c = 0.628
b+c = 2.094 > 1
Thus, Britannia has an Increasing Returns to Scale.


GRAPHICAL REPRESENTATION OF TOTAL PRODUCT,
AVERAGE PRODUCT AND MARGINAL PRODUCT
Total product: This the total quantity of output produced by a firm from a given quantity
of inputs. Total product is the foundation upon which the anlysisof short production for a
firm is based. The total product of hero motocorp is presented graphically as following.
Sales are considered to be units or output whereas, compensation is considered as labour.

Average product: The quantity of total output produced per unit of a variable input,
holding all other inputs fixed. Average product, usually abbreviated AP, is found by dividing
total product by the quantity of the variable input. The graphical presentation of AP is as
following:

y = 2043x - 8543.9
R = 0.8113
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Compensation Of Employees
TOTAL PRODUCT
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Compensation Of Employees
Marginal product: This is the change in total product resulting from a change in the
number of workers. As an example, Marginal product indicates how the total production of
TexMex Gargantuan Tacos changes when an extra worker is hired or fired. For example,
hiring a 5th worker means that Waldo's TexMex Taco World total product increases from
95 to 110 tacos. The addition of a 5th worker results in the production of an additional 15
TexMex Gargantuan Tacos. The graphical presentation of MP for Britannia Industries is as
following:













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Compensation Of Employees
UNIVERSITY BUSINESS SCHOOL



BUSINESS ECONOMICS ASSIGNMENT
(2014-16)

SUBMITTED TO SUBMITTED BY
PROF.MANOJ KUMAR SHARMA ANKIT MEHAN
MBA (GEN) SECTION-A