Constant Returns to Scale

Definition

Constant returns to scale is a property of a production function where an increase in all inputs by a certain factor leads to an equal proportional increase in output. In other words, doubling all inputs will exactly double the output.

5 Must Know Facts For Your Next Test

1. Constant returns to scale implies that a 1% increase in all inputs will result in a 1% increase in output.
2. This means that the average cost of production remains constant as the scale of production changes.
3. Constant returns to scale is one of the three possible types of returns to scale, the other two being increasing returns to scale and decreasing returns to scale.
4. Constant returns to scale is often observed in industries with mature, standardized production processes and technologies.
5. The presence of constant returns to scale has important implications for a firm's long-run cost structure and optimal scale of production.

Review Questions

• Explain how constant returns to scale affects a firm's production decisions in the long run.
  • With constant returns to scale, a firm's average cost of production remains the same regardless of the scale of production. This means the firm can expand its output without experiencing changes in its average cost. As a result, the firm can produce at the scale that maximizes its profits without being constrained by increasing or decreasing returns to scale. The firm's long-run supply curve will be perfectly elastic, indicating that it can produce any quantity at the same average cost.
• Describe how the concept of constant returns to scale is related to the shape of the firm's long-run average cost curve.
  • Under constant returns to scale, the firm's long-run average cost curve will be horizontal, or flat. This indicates that the average cost of production does not change as the firm's scale of production increases. The firm can expand its output without experiencing economies or diseconomies of scale. The horizontal long-run average cost curve reflects the fact that a 1% increase in all inputs will result in a 1% increase in output, leaving the average cost unchanged.
• Evaluate the implications of constant returns to scale for a firm's optimal scale of production and market structure.
  • With constant returns to scale, there is no single optimal scale of production for the firm. The firm can produce at any scale and maintain the same average cost. This means the firm is not constrained in its ability to expand or contract production to meet demand. In a market with constant returns to scale, the market structure is likely to be more competitive, as there are no significant economies or diseconomies of scale that would lead to natural monopolies or oligopolies. Firms can freely enter and exit the market without facing significant cost disadvantages, promoting a more competitive environment.

Related terms

Production Function:

A mathematical relationship that shows the maximum amount of output that can be produced from various combinations of inputs.

Economies of Scale:

The cost advantages that businesses obtain due to expansion, with cost per unit of output decreasing with increasing scale of production.

Diminishing Marginal Returns:

The principle that as more of a variable input is added to a fixed input, the marginal product of the variable input will eventually decrease.