Production in the Long Run 199output by replicating its current plant and labor force, that is, by building an
identical plant beside the old one.
Increasing returns to scaleoccur if a given percentage increase in all inputs
results in a greater percentage change in output. For example, a 10 percent
increase in all inputs causes a 20 percent increase in output. How can the firm
do better than constant returns to scale? By increasing its scale, the firm may
be able to use new production methods that were infeasible at the smaller scale.
For instance, the firm may utilize sophisticated, highly efficient, large-scale fac-
tories. It also may find it advantageous to exploit specialization of labor at the
larger scale. As an example, there is considerable evidence of increasing
returns to scale in automobile manufacturing: An assembly plant with a capac-
ity of 200,000 cars per year uses significantly less than twice the input quanti-
ties of a plant having a 100,000-car capacity. Frequently, returns to scale result
from fundamental engineering relationships. Consider the economics of an
oil pipeline from well sites in Alaska to refineries in the contiguous United
States. Doubling the circumference of the pipe increases the pipe’s cross-
sectional areafourfold—allowing a like increase in the flow capacity of the
pipeline. To sum up, as long as there are increasing returns, it is better to use
larger production facilities to supply output instead of many smaller facilities.
Decreasing returns to scaleoccur if a given percentage increase in all
inputs results in a smaller percentage increase in output. The most common
explanations for decreasing returns involve organizational factors in very large
firms. As the scale of the firm increases, so do the difficulties in coordinating
and monitoring the many management functions. As a result, proportional
increases in output require more than proportional increases in inputs.
Output elasticityis the percentage change in output resulting from a 1 per-
cent increase in all inputs. For constant returns to scale, the output elasticity
is 1; for increasing returns, it is greater than 1; and for decreasing returns, it is
less than 1. For instance, an output elasticity of 1.5 means that a 1 percent scale
increase generates a 1.5 percent output increase, a 10 percent scale increase
generates a 15 percent output increase, and so on.CHECK
STATION 3Reexamine the production function in Table 5.1. Check that production exhibits increas-
ing returns for low levels of input usage and decreasing returns for high levels of usage.
Can you find instances of constant returns in the medium-input range?Returns to
Scale in
Coal MiningA study of surface (i.e., strip) coal mining estimated production functions for
deposits of different sizes.^5 The study was based on a survey of Illinois mines
that included information (for each mine) on the production of coal (in tons),
the amount of labor employed (in hours), the quantity of earth-moving capi-
tal (in dollars), and the quantity of other capital (also in dollars). Significant(^5) G. A. Boyd, “Factor Intensity and Site Geology as Determinants of Returns to Scale in Coal
Mining,” Review of Economics and Statistics (1987): 18–23.
c05Production.qxd 9/5/11 5:49 PM Page 199