No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Seven: Production: Man at Work 161 RETURNS TO SCALE Our initial production function allows us to model what one firm could do to produce goods and services, and we begin to see the tradeoff between productive inputs. Yet another question may quickly come to mind: how big should the firm be? Or what should the scale of production be? This can be more formally treated with the concept of returns to scale . Let’s say Ford wants to build a new vehicle such as they did in 2020 with the new Bronco. Demand is expected to be high, and they’d like to build 300,000 units each year. Should they build one large factory, and produce them all? Or should they build three smaller factories and have them build 100,000 units each? Or should they have one factory in each state and build 6,000 vehicles each? If Ford has 100,000 plants, each producing three vehicles per year, there is a lot of overhead in order to maintain all the different buildings. Ford would only have a few workers in each “plant” (more like a garage!), and each worker would have to perform many parts of the production process. Imagine all the extra delivery work to supply the parts to all those “plants.” By increasing the scale of production to only three plants, each producing 100,000 vehicles, Ford is able to concentrate its managerial focus on how to use the resources in those three plants. The workers are able to specialize in a given task and become very efficient. Their increased efficiency will result in additional production as well as higher quality—the benefits of increasing returns to scale. It’s possible that a single plant may be even more efficient, or conversely, the span of control might be too much and it might be less efficient. Or there might not be enough quality workers at one location, and it is better to have plants in multiple locations. Entrepreneurs have a financial incentive to size their production facilities at the optimal size; you can bet they will carefully consider this choice. There are three types of returns to scale that we might see (and the mathematical formulas which express them): 1. Constant Returns to Scale aQ = f ( aL,aK ) 2. Increasing Returns to Scale aQ < f ( aL,aK ) 3. Decreasing Returns to Scale aQ > f ( aL,aK ) If a company (1) faces constant returns to scale, as it doubles its productive inputs, its output will exactly double, (i.e., 2Q = f(2L,2K)). This might be the case where there are Returns to scale: refers to how much output increases with a given increase in productive inputs. Returns to scale focuses on how much more efficient a firm can become in production as it grows larger.