Decreasing returns to scale: Meaning, Criticisms & Real-World Uses

What Is Decreasing Returns to Scale?

Decreasing returns to scale (DRS) occur in production theory when increasing all inputs to a production process by a certain proportion results in a less than proportional increase in output. This economic phenomenon suggests that, beyond a certain point, scaling up a firm's operations becomes less efficient, leading to higher cost per unit. It is a fundamental concept within microeconomics that describes the long-run relationship between changes in the scale of production and the resulting change in the quantity of output. When a business experiences decreasing returns to scale, its production efficiency diminishes as its size and production capacity expand.

History and Origin

The concept of returns to scale, encompassing increasing, constant, and decreasing returns, has roots in classical economics, but it was formally defined and extensively analyzed by economist Alfred Marshall in his 1890 work, Principles of Economics. Marshall utilized the idea of returns to scale to describe situations where firms might encounter advantages (economies of scale) or disadvantages (diseconomies of scale) related to their size. His work provided a crucial framework for understanding how changes in the scale of inputs affect the resulting output in the long run.⁷ Subsequent economists, including Knut Wicksell and Piero Sraffa, further refined and clarified the technical definition of returns to scale, emphasizing their dependence on the underlying production function.⁶

Key Takeaways

Decreasing returns to scale indicate that doubling all production inputs leads to less than a doubling of output.
This phenomenon often results from organizational complexities, management inefficiencies, or resource constraints as a firm expands.
It signifies an increase in the average costs of production as output increases beyond a certain point.
Understanding decreasing returns to scale is crucial for businesses in strategic planning and resource allocation to avoid over-expansion.
DRS is distinct from the law of diminishing marginal returns, which applies when only one input is varied while others are held constant.

Formula and Calculation

Decreasing returns to scale are observed when, for a production function (Q = f(L, K)) (where (Q) is output, (L) is labor, and (K) is capital), increasing both (L) and (K) by a factor of (t) results in output increasing by a factor less than (t). Mathematically, this can be expressed as:

f(tL, tK) < t \cdot f(L, K) \quad \text{where } t > 1

In a Cobb-Douglas production function, often represented as (Q = A L^{\alpha K}\beta), decreasing returns to scale occur if the sum of the exponents (\alpha + \beta < 1). Here:

(Q) represents the total output.
(A) is the total factor productivity.
(L) represents the quantity of labor inputs.
(K) represents the quantity of capital inputs.
(\alpha) and (\beta) are the output elasticities of labor and capital, respectively.

This formula demonstrates that even with proportional increases in all inputs, the growth in output is stifled, leading to higher cost per unit.

Interpreting Decreasing Returns to Scale

Interpreting decreasing returns to scale involves recognizing that simply expanding the scale of operations does not guarantee proportional increases in productivity or profit. When a company observes decreasing returns to scale, it suggests that its current scale of operation may be beyond its optimal point, where economic efficiency is maximized. This can manifest as rising average costs or a decline in overall production efficiency. For instance, if a manufacturing plant doubles its factory size and workforce but sees its output increase by only 70%, it is operating under decreasing returns to scale. This signals a need to re-evaluate resource allocation and operational strategies, as further expansion of the entire production process may lead to higher costs per unit produced rather than benefits.

Hypothetical Example

Consider "MegaMart," a rapidly expanding retail chain that initially experienced significant economies of scale. They have 100 stores, each with 50 employees and a standardized supply chain management system, yielding an average daily revenue of $20,000 per store.

To achieve further market dominance, MegaMart decides to double its operations, building another 100 stores and hiring 5,000 more employees (doubling its total inputs). However, due to several factors—such as increased complexity in coordinating 200 locations, challenges in maintaining consistent training quality across a larger workforce, and difficulties in optimizing logistics for a vastly expanded network—the total daily revenue does not double. Instead, it increases to $3,500,000 across all 200 stores.

Initial State: 100 stores, 5,000 employees, $2,000,000 total daily revenue.
Expansion: Doubled to 200 stores, 10,000 employees (all inputs doubled).
Resulting Output: $3,500,000 total daily revenue.

Here, a 100% increase in inputs (stores, employees) led to only a 75% increase in output ($3,500,000 / $2,000,000 = 1.75 or 75% increase). This illustrates decreasing returns to scale, as the output increased by a less than proportional amount compared to the increase in inputs. MegaMart's cost per unit of revenue likely increased, impacting its overall profitability.

Practical Applications

Decreasing returns to scale are a critical consideration across various sectors, influencing strategic decisions in businesses, investment, and public policy. In manufacturing, a company might initially benefit from larger production runs, but beyond a certain capacity, adding more machinery or workers might lead to congestion, coordination issues, and diminishing gains, making the production process less efficient. For instance, a factory may find that adding more assembly lines leads to overcrowding and frequent breakdowns rather than proportionally higher output.

In the services sector, especially in areas like customer support or consulting, rapid expansion can dilute service quality due to insufficient training or communication breakdowns among a larger workforce, negatively impacting client satisfaction and effective output. Fur⁵thermore, in resource-intensive industries such as mining or agriculture, continued extraction or cultivation from a fixed area can eventually yield progressively smaller returns as the most accessible resources are depleted or the land becomes over-utilized. Thi⁴s concept also applies to large organizational structures where bureaucratic layers increase, leading to slower decision-making and reduced responsiveness, thereby hindering overall competitive advantage. Eve³n in fields like health economics, empirical studies have explored the presence of decreasing returns to scale in health production functions, examining how inputs like medical care and lifestyle choices translate into health outcomes.

##² Limitations and Criticisms

While decreasing returns to scale offer a valuable framework for understanding limits to growth, the concept faces certain limitations and criticisms. One challenge lies in isolating the precise causes of diminishing returns in real-world scenarios, as numerous internal and external factors can impact a firm's output. Critics argue that the rising portion of the long-run average cost curve, which indicates decreasing returns, is sometimes weakly explained, often attributed broadly to "diseconomies of management" or difficulties in coordinating numerous production units.

Fu¹rthermore, the theoretical assumption that all inputs can be scaled up perfectly proportionally might not hold true in practice. Some inputs, like managerial talent or unique technological insights, are not infinitely divisible or replicable. A company might struggle to find enough skilled managers to oversee an exponentially growing workforce, leading to supervisory inefficiencies and communication breakdowns. Additionally, external factors beyond a firm's control, such as market saturation, increased competition for variable costs like raw materials, or infrastructure bottlenecks, can mimic decreasing returns to scale, even if the internal production process remains theoretically efficient at scale. This makes it challenging to distinguish between internal inefficiencies and external market pressures.

Decreasing Returns to Scale vs. Economies of Scale

Decreasing returns to scale are often discussed in contrast to economies of scale, representing opposite phenomena in a firm's long-run production.

Feature	Decreasing Returns to Scale	Economies of Scale
Output Response	Output increases by less than the proportional increase in all inputs.	Output increases by more than the proportional increase in all inputs.
Average Cost	Average costs per unit of output tend to increase.	Average costs per unit of output tend to decrease.
Efficiency	Implies a decline in economic efficiency as scale grows.	Implies improved economic efficiency as scale grows.
Underlying Cause	Often due to managerial inefficiencies, coordination problems, or resource strain.	Often due to specialization, bulk purchasing, or technological advantages.
Strategic Implication	Signals potential over-expansion; may necessitate scaling back or restructuring.	Encourages growth to achieve lower production costs.

The confusion between the two arises because both relate to how a firm's scale of operation impacts its efficiency and costs. However, they describe opposing outcomes. Economies of scale occur when a larger scale of production leads to lower cost per unit, whereas decreasing returns to scale describe the situation where expanding beyond a certain optimal point results in higher cost per unit. Businesses typically aim to achieve economies of scale and avoid the onset of decreasing returns to scale.

FAQs

What causes decreasing returns to scale?

Decreasing returns to scale are often caused by difficulties in managing and coordinating a very large operation. As a company grows, communication can become less effective, decision-making processes can slow down, and there can be a loss of employee motivation or oversight. Technical limitations in equipment or processes can also contribute, where adding more units of the same input (like machines or workers) eventually leads to congestion or less efficient utilization of existing fixed costs.

Is decreasing returns to scale the same as diminishing marginal returns?

No, they are distinct concepts, though related. Decreasing returns to scale refer to the long run, where all inputs (like labor and capital) are increased proportionally, and the total output grows by a smaller proportion. Diminishing marginal returns, on the other hand, apply in the short run when only one input is increased while other inputs remain constant. For example, adding more workers to a fixed number of machines can eventually lead to each additional worker contributing less to total output.

How can a company avoid decreasing returns to scale?

To avoid decreasing returns to scale, a company should carefully manage its growth and be aware of the optimal scale for its operations. Strategies include investing in better supply chain management and organizational structures, decentralizing decision-making to improve responsiveness, enhancing communication channels, and focusing on employee training and motivation. Evaluating the marginal benefit of expanding production capacity is crucial to ensure that growth continues to yield proportional or greater increases in output.