Constant returns to scale- Application In Business

In economics, returns on investment refer to what occurs after all inputs into the production process, including human capital use, are accounted for. The idea of returns on investment also arises in the case of a business's production function. It is a basic economic principle that a firm must continuously add new resources (raw material and labor) in order to reproduce its existing value added output, i.e., increase its net value. There is a key concept here: there is only a finality, a limit to growth, when a firm has exhausted all of its existing inputs. Beyond this limit, there are two possible scenarios: either the new or the existing value added output is equal to or exceeds the initial value added; or, the existing value added output is lower than the new value added output.

In both cases, the outcome is the same: a marginal product is produced at a decreasing rate until the end of the process, at which point it is no longer feasible to produce any more. The concept behind constant returns to scale is therefore that an initially successful business will tend to reach a plateau, at which point the business can experience a proportional increase in output until the process ends, at which point output stops increasing forever, meaning the company has reached a dead end. Thus, to continue to grow, a company must continually add new input units, but this process cannot continue indefinitely because eventually the number of input units needed to meet demand will reach the point where further growth is no longer viable. If, for example, the business grows in size and complexity, then a finite amount of potential revenue can be generated.

The concept of constant returns to scale is not unique to manufacturing. In engineering, the rate at which the firm designs and builds a component, model, or machine cannot be predicted because the actual performance of the component, model, or machine is unknown at the time of design and construction. Therefore, it is necessary to adopt a delayed response, which is then used as a guide in the production process. If, for example, the engineer determines that the firm needs to build ten machine units per month in order to meet demand, the company must then plan to produce ten units per month for the first six months to a year; at the end of the period, if demand continues to increase, additional machines are built, and production resumes its delayed path. This example illustrates the process by which companies make use of delayed response techniques in their production processes.

As mentioned above, diminishing returns to scaling are not limited to the production function alone. In all industries, the level of inputs required to produce finished goods rises as new technological and economic conditions require ever larger amounts of input materials to produce the final product. The process through which these larger numbers of inputs are produced, called fabrication, consumes a large amount of human capital, thereby limiting profits. Likewise, if inputs to produce final goods continue to increase at a faster pace than the pace of production, factories and other operations are forced to shut down.

In any industry, decreasing returns to scaling can occur in either the process or the product development process. In the process, technological and economic developments limit the number of firms that can be operated in any given geographic area. In product development, numerous processes become involved before the final product quality is established. While these two examples illustrate the potential for large returns to scaling in various types of operations, they also provide grounds for optimism regarding future manufacturing efficiency. If a company is able to successfully reduce inputs, improve designs, and introduce innovative production processes, there is a reasonable chance that the manufacturer will experience decreasing returns to scale.

It is unrealistic to anticipate all factors that affect the way that a firm operates, but present-day evidence suggests that the rate of return on investment for most types of manufacturing processes is rather constant. Since technology setpoints are difficult to change without causing a marked decrease in output over time, it may not be possible to anticipate every possible set point and react accordingly. Nevertheless, most analysis indicates that overall, a firm will experience constant returns to scale throughout its production history. Whether a manufacturer's level of productivity increases or decreases between different points in time depends largely on the inputs that are being used, as well as on the environment in which the production takes place. When constant returns to scale are realized and managed effectively, a company has a much greater chance of maintaining consistent profit levels regardless of how the economy fluctuates.

Read about the constant returns to scale and their relation with producer and other laws on thekeepitsimple