Law of Increasing Returns: Reasons for Application and Relationship with Increased Production

Introduction

In the study of production economics, the Law of Increasing Returns plays a vital role in explaining how the productivity of a firm changes when the scale of production is increased. This law is a fundamental part of the broader Laws of Returns to Scale, which describe the relationship between input and output in the long run, when all factors of production can be varied.

The Law of Increasing Returns states that as the quantity of one or more inputs increases, keeping other factors constant, total output increases at an increasing rate. In simpler terms, the productivity of each additional unit of input rises, leading to greater efficiency and reduced cost per unit. This phenomenon is common in the early stages of industrial or large-scale production.

This concept not only explains how businesses grow but also how industries evolve, achieve economies of scale, and contribute to overall economic development.

Meaning and Definition of the Law of Increasing Returns

The Law of Increasing Returns describes a situation where the proportionate increase in output is greater than the proportionate increase in inputs. It occurs when a firm expands its scale of production and achieves higher efficiency due to better organization, specialization, and use of modern technology.

Formal Definition

According to Prof. Marshall:

“An increase of labour and capital leads generally to improved organization, which increases the efficiency of the work of labour and capital.”

In other words, when more units of variable inputs (like labor and capital) are used with a fixed factor (like land or machinery), total production increases more than proportionately due to improved coordination and division of labor.

Illustration of the Law

Let us assume that a factory uses units of labor and capital to produce goods.

Units of Input	Total Output (in units)	Marginal Output	Nature of Returns
1	100	–	–
2	220	120	Increasing Returns
3	360	140	Increasing Returns
4	520	160	Increasing Returns

In the above example, as input units increase from 1 to 4, total output increases more than proportionately — showing an increasing rate of return. This means efficiency is improving with expansion, indicating that the law of increasing returns is in operation.

Theoretical Explanation

The law operates mainly due to internal and external economies of scale that arise from expanding production. These economies enable the producer to use resources more effectively, lower average costs, and achieve higher productivity per unit of input.

The law is more applicable in the initial stages of production when resources can be better coordinated, and specialization is possible. However, after a certain point, if the scale continues to expand, the Law of Diminishing Returns may eventually set in due to inefficiencies, management difficulties, or resource limitations.

Assumptions of the Law

For the Law of Increasing Returns to hold true, certain assumptions must be met:

1. Efficient Organization: There must be improved coordination and managerial efficiency as production increases.
   
   
2. Homogeneous Inputs: All units of inputs used (labor, capital, etc.) must be of similar quality.
   
   
3. Constant Technology (Initially): Technology is assumed to be constant in the short run but can improve in the long run.
   
   
4. Perfect Competition: The market operates under perfect competition where resources are efficiently utilized.
   
   
5. Divisibility of Inputs: Factors of production are divisible and can be increased in variable proportions.
   
   
6. Rational Producers: Producers aim to maximize profit through efficient resource allocation.

Reasons for the Application of the Law of Increasing Returns

The law operates due to several economic and technological reasons. These reasons can be broadly classified into internal economies (arising within the firm) and external economies (arising from industrial or market conditions).

1. Division of Labour and Specialization

• When production is carried out on a large scale, workers can specialize in particular tasks, increasing efficiency and speed.
  
  
• Division of labour allows workers to focus on specific operations, improving productivity and reducing wastage of time.
  
  
• For example, in an automobile assembly line, each worker handles a small, repetitive task, resulting in faster and more efficient production.

2. Better Utilization of Fixed Factors

• In the early stages, some fixed factors like machinery or land remain underutilized.
  
  
• As production increases, these fixed resources are more fully utilized, spreading overhead costs over more units of output.
  
  
• This reduces the average cost per unit and increases the overall return on investment.

3. Technological Advancements

• Expansion in production often enables firms to adopt improved technology, modern machinery, and automation.
  
  
• Advanced techniques result in higher productivity, consistent quality, and cost efficiency.
  
  
• Thus, increasing returns are often a result of technological progress and innovation.

4. Economies of Scale

• Large-scale production results in both internal and external economies of scale.
  • Internal Economies include managerial, technical, financial, marketing, and risk-bearing advantages within the firm.
    
    
  • External Economies include advantages arising from industrial growth, better infrastructure, and supplier networks.
• These economies lead to reduced average costs and higher productivity.

5. Improved Organization and Management

• As production expands, firms can afford to hire specialized managers and adopt better organizational structures.
  
  
• Efficient coordination between departments leads to smoother workflow and higher returns.

6. Increased Bargaining Power

• Large producers can negotiate better deals for raw materials, machinery, and credit facilities.
  
  
• This results in reduced input costs and improved profit margins.

7. Indivisibility of Factors

• Some inputs like large machinery or transport systems cannot be divided into smaller units.
  
  
• As production expands, these indivisible inputs are used more efficiently, resulting in higher output per unit cost.

8. Learning by Doing

• As workers and management gain experience, they become more proficient in their roles.
• This “learning effect” contributes to increasing productivity and efficiency over time.

9. Availability of Skilled Labor

• Industrial expansion often attracts skilled workers to specific regions or sectors.
• This concentration of skilled labor increases efficiency and enhances the productivity of the entire industry.

10. Market Expansion

• As production rises, the firm can sell products in larger markets, benefiting from increased demand and better distribution.
  
  
• Large-scale marketing and advertising become feasible, supporting further growth and profitability.

Relationship between Increasing Returns and Increased Production

The law of increasing returns is directly connected with the phenomenon of increased production. The relationship can be explained through the following points:

1. Proportionate Increase in Output

• Under increasing returns, a given percentage increase in inputs results in a greater percentage increase in output.
  
  
• For example, a 20% increase in labor and capital might lead to a 40% increase in production, showing that efficiency improves with scale.

2. Reduction in Average Cost

• As production expands, fixed costs are spread over a larger number of units, reducing average costs.
  
  
• Lower costs encourage producers to increase output further, reinforcing the cycle of growth.

3. Economies of Scale and Production Efficiency

• The law of increasing returns and economies of scale are closely related.
  
  
• As a firm expands, it benefits from cost reductions due to better resource utilization, advanced machinery, and improved organization, leading to increased output.

4. Encouragement to Capital Investment

• Rising returns and profits attract further investment in production facilities, technology, and human resources.
  
  
• This investment leads to a higher level of production and productivity over time.

5. Technological and Organizational Growth

• Expansion often brings innovation in processes, automation, and better quality control.
  
  
• These factors further strengthen the link between increasing returns and higher output.

6. Multiplier Effect in the Economy

• When industries experience increasing returns, they generate employment, raise incomes, and stimulate demand for other goods.
  
  
• This creates a positive feedback loop — increased demand encourages more production, leading to further increasing returns.

7. Competitive Advantage and Market Expansion

• Firms achieving increasing returns can lower prices and gain market share.
• The resulting higher sales volume promotes continuous growth in production.

Graphical Explanation

The Law of Increasing Returns can be represented graphically using a Total Product (TP) curve:

• Initially, the TP curve rises slowly as inputs increase.
  
  
• As the firm experiences increasing returns, the TP curve becomes steeper, showing faster growth in output.
  
  
• Eventually, as constraints set in, the curve starts flattening, indicating diminishing returns.

This shows that increasing returns dominate in the early stage of production, leading to rapid output growth.

Importance of the Law of Increasing Returns

1. Basis of Industrial Growth

• The law explains how industries grow and achieve large-scale production through efficiency and specialization.

2. Reduction in Cost and Price

• With increased output and better resource use, cost per unit falls, allowing firms to offer products at lower prices.

3. Higher Profits

• Lower production costs combined with steady or growing demand result in higher profit margins.

4. Encouragement for Expansion

• The possibility of achieving increasing returns encourages firms to expand production and invest in advanced technology.

5. Employment Generation

• Expansion in production and the establishment of large-scale industries create employment opportunities across sectors.

6. National Economic Growth

• When multiple industries experience increasing returns, the overall production and income levels in the economy rise, promoting national development.

7. Foundation for Economies of Scale

• The concept of increasing returns underpins modern theories of scale economies and efficiency in production systems.

Limitations of the Law

1. Limited Applicability:
   The law applies mainly to industries where economies of scale are possible (e.g., manufacturing), not in sectors like agriculture.
   
   
2. Eventually Leads to Diminishing Returns:
   After a certain level of expansion, inefficiencies and coordination problems may arise, leading to diminishing returns.
   
   
3. Requires Large Capital Investment:
   Expansion and modernization demand heavy investment, which small firms may not afford.
   
   
4. Assumes Constant Technology Initially:
   The law may not hold true if technology changes frequently during the production process.

Conclusion

The Law of Increasing Returns is a cornerstone of production theory. It explains how, in the initial stages of industrial expansion, output increases more than proportionately to input, resulting in higher efficiency and reduced costs. The law operates due to factors such as specialization, better organization, economies of scale, and technological advancement.

The relationship between increasing returns and increased production is direct and reinforcing. As production rises, costs decline, profits grow, and industries expand further, promoting employment and economic development. However, this law is not indefinite; beyond a certain point, diminishing returns may emerge due to resource limitations or inefficiencies.

Overall, the Law of Increasing Returns highlights the importance of efficient resource utilization, large-scale operations, and innovation in achieving sustainable economic growth.