The law of diminishing returns only applies in the Short Run, when only one factor of production is variable and can be increased. The other factors of production are fixed. Thus as the variable factor of production is increased the marginal product of that factor will rise at first, but will at some point begin to fall.
Returns to scale can only occur when no factors of production are fixed. If the quantities of all of the factors of production are increased, then output will also increase. However, the amount by which output rises can either be proportionately more than the amount that the factors of production were increased by, proportionately less, or the same. These cases are called increasing returns to scale, decreasing returns to scale, or constant returns to scale.
The law of diminishing returns is also called the law of variable proportion, as the proportions of each factor of production employed keep changing as more of one factor is added. In a factory, the factor of production most easily varied is labour. Thus when the factory needs to increase output quickly it is likely to take on more workers. This will lead to the marginal product rising at first, because each additional worker will increase output by more than they increase the firms’ costs. However eventually there will be too many workers, and too few machines for them to use. This means the marginal product will fall, and the firm is not producing efficiently.
When the firm needs to increase its production by more than the amount available by varying one factor, it needs to also vary the other factors. The firm would need to buy more land, capital, enterprise and labour; that is increase all of the factors of production, which is only possible in the long run. As the firm increases in size, it will achieve increasing returns to scale, or economies of scale, for several reasons.
Technical economies of scale occur because some factors of production are indivisible, such as machinery. The addition of a new machine will lead to a small increase in costs and a large increase in output for a large firm, but a smaller firm would be unable to operate it as much, so the cost to a small firm for each unit produced with the machine will be greater.
The firm can specialise more, so that each worker concentrates on one task, which will mean that each worker will need less training, and can learn how to do each task better. Also, no time is lost changing from one task to another, and so speed, accuracy and, ultimately, productivity will increase.
The law of increased dimensions, also a technical economy of scale, states that to double the capacity of warehouses, transporters and other storage, you do not need to double the dimensions or workers, so the costs will not double.
Marketing economies of scale occur when large firms have more power, so that they can negotiate better deals with their suppliers and obtain their raw materials at a lower cost. They can negotiate good deals with their wholesalers too, whereas smaller firms would have to buy and sell at the market price.
The financial economies available to large firms are due to the interest rate on large bank loans being lower, as a large company can secure the loan and is therefore a lower risk. This means that when large firms need to borrow money for investment, they can do so more easily.
All of these increasing returns to scale mean that as a firm grows the long run average cost curve falls, so the firm is becoming more efficient and can produce at a lower cost.
However, as the firm continues to grow, it may start to experience decreasing returns to scale. They are mainly incurred when a firm has to coordinate production in a large factory, as the whole factory has to be controlled by a central team of managers. Thus production may begin to break down due to poor coordination of resources, which will raise costs, or be prevented by an increase in managers, which will also increase costs. For very large outputs, these problems will dominate, and any economies of scale achieved by the firm will be overridden. However, this managerial breakdown may be because as the firm has grown and the factors of production have increased the number of managers has not increased by the same proportion. In practice, this makes decreasing returns to scale hard to justify, so it remains a theoretical concept.
The main differences between the law of diminishing returns and returns to scale are that one is a concept in the short term, while the other can only occur in the long term. A firm can use both to increase output, and both can lead to unwanted negative effects, if taken too far. However, a firm can maximise its profits after the marginal product of the variable factor has started to fall, as long as employing the additional factor of production adds more to the firms’ total revenue than it does to costs. If a firm is experiencing decreasing returns to scale, on the other hand, it is no longer maximising profits.