Creating Value

In the above figure OA and OB are the product lines indicating two hypothetical techniques of production and isoquants Q₁ (10units), Q₂ (18units) and Q₃ (40units) indicate three different levels of output. When both the inputs are doubled, i.e. from 1K+1L to 2K+2L the output increases from 10units to18units (that is 80% increase), which is less than the proportionate increase in inputs. Similarly the movement from point b to c indicates the increment in the inputs by 50%, whereas the increment in output is only 33.33%. This shows decreasing returns to scale.

REASONS OF DECREASING RETURNS TO SCALE:

Decreasing returns to scale arises mainly because of diseconomies of scale. Some of the diseconomies which cause decreasing returns to scale are;

Ø MANAGERIAL INEFFICIENCY:

Diseconomies begin to start first at the management level. Managerial inefficiencies arise from expansion of scale itself, which eventually decreases the level of output.

Ø EXAHAUSTABILITY OF NATURAL RESORSES:

It also leads to the decreasing returns to scale. For e.g. doubling the size of the coal mining plant does not double the coal output because of limitedness of coal deposits or difficult accessibility to coal deposits.

Ø INEFFICIENT CONTROL:

When the size of the firm is small the owner can efficiently handle and control all the departments individually. With increase in size of the firm (increase in inputs and outputs), various departments are created. Thereby controlling efficiency may decrease creating hindrances in production.