In economics, decreasing returns to scale refer to what occurs when the output level of an enterprise increases as the output level of physical resources increases, especially when all physical inputs such as physical capital use are accounted for. The basic concept of decreasing returns to scale is based on the production function of a company. In such functions, output equals output less depreciation that can be accounted for by either total factor productivity or the level of fixed costs involved in producing the output. The concept of diminishing returns to scale is used to describe processes which involve changes in inputs, output, and total factor productivity. These processes can be described in terms of their potential impact on output and associated costs.
For example, suppose that the inputs A and B are both measured in thousand kilograms per year. In year one, the output is just equal to A. In year two, output increases by ten thousand kilograms. This decreasing returns to scale comes as a result of changes in production technology, labor input, and accounting measures. Year three, the initial output still equates with A.
Assuming that production technologies, labor inputs, and accounting measures remain unchanged, it follows that the value of A in year one has risen because of increases in prices of raw materials and labor while output has not changed. If we then assume that over the course of production the prices of both A and B continue to rise, the value of A should fall as production adjusts to reflect the higher prices of A and B. This would imply that the returns to scale have diminished. However, the concept of constant returns to scale could be challenged by the fact that prices of inputs should only go up slightly for each successive output increment without corresponding decreases in the cost of production.
One potential challenge to the standard definition of decreasing returns to scale is the assumption that production should always take the optimal output for every input. Many real-world managers are guided by the theory of diminishing marginal returns to scale. They attempt to maximize output regardless of input costs. For example, an automobile manufacturer may decide to build the most efficient assembly line possible even if it means that it builds fewer cars than desired, since increasing production output will bring down its total cost of production. The purpose of this decision is to maximize profits without regard to whether the end product is worth the additional investment.
A different worry with the theory of decreasing returns to scale is the idea that markets will become too small if there are significant increases in inputs without corresponding increases in production. This can lead to overproduction or zero production. The concern here is that if inputs continue to rise, markets might not be able to accommodate increases in input costs. To test this concern, a business that produces constant commodity goods can be given a different set of inputs and see how much of each product goes to waste. The overall level of output would then be expected to be the same as with no increases in inputs. Obviously, the market would no longer be too small.
Another worry about decreasing returns to scale with fixed costs is the idea that increasing inputs will reduce total revenue. One argument against this is that, because fixed costs are assumed to increase over time, customers will eventually be better satisfied with increased inputs. This will lead to more output and thus, an increase in revenue. If customers feel that they get better value for money because prices have remained fixed, they will be less likely to switch suppliers if they feel that prices are already high.
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