Dear k9queen-ga,
Good day!
The decreasing returns to scale will be observed when a given
proportionate increase in ALL resources in the long run results in a
proportionately smaller increase in production. For example, if a firm
increases all the resources -- labor, capital, and other inputs -- by
5%, and output increases by less than 5%, we say that decreasing
returns to scale exist.
For example, when Akio Morita tried to export a Sony transistor radio
to the USA in 1955, he found that the demand (> 100,000 units/month)
far outstripped his production capacity (1,000 units/month). Morita
understood that to satisfy the demand, Sony would have to hire and
train new employees and expand its facilities even more. This would
mean a major investment, a major
expansion, and a gamble. They didn't know if the demand for repeat
business would be high enough to justify the additional investment.
To arrive at an objective decision, he drew a curve of that looked
like a lopsided letter ‘U.’ He noted that the curve began at the
minimum order lot (5,000 units) when Sony didn't offer any discounts.
The curve then reached its nadir at 10,000 units where there was a
discount, and then, again, the price per unit began to climb.
The reason for this behavior was that beyond 10,000 units a year, the
cost of production was increasing as the company had to hire more
workers, pay overtime, etc. What Morita had drwan was, in effect, an
Average Total Cost curve. Such cost curves are very useful in
determining scales.
The economic justification for the different returns to scale (besides
decreasing returns, there are constant returns and increasing returns
to scale as well!) turns out to be far from simple.
Decreasing returns to scale implies that by doubling inputs we less
than double output. The naive justification is that the size of
production has overstretched itself. The advantages of specialization
are being outweighed by the disadvantages of, say, managerial
coordination of an enterprise of such great scale. This "managerial
breakdown" explanation is not really legimitate because we have not
increased one of the factors, namely, the managers themselves.
There is also an empirical reason for doubting the existence of
decreasing returns - it would not be "rational" for an enterprise to
ever produce in such a situation. Suppose there is an entrepreneur who
has a given set of laborers and machines willing to work for him. He
can either put all these factors into a single factory, or just
construct a series of smaller, but identical factories. Obviously, if
he faced decreasing returns to scale, he would have opted for several,
decentralized, separate factories rather than throwing them all
together into a single, centralized factory.
Although most textbooks continue to refer to the possibility of
decreasing returns to scale, they also often add parenthetically that
they are assuming a fixed factor, or indivisibilities or some other
imperfection that somewhat violates its pure definition.
Hope this addresses your query satisfactorily :)
Thanks & regards,
reeteshv-ga
Additional Links:
A glossary of economics terms is available here:
http://www.amosweb.com/
The Sony example was taken from a presentation prepared by Prof.
Robert Marks of the website of Australian Graduate School of
Management of the University of New South Wales:
http://www.agsm.edu.au/~bobm/teaching/MA/M4a.pdf
An excellent commentary on titled "Returns to Scale" is available
here:
http://cepa.newschool.edu/het/essays/product/returns.htm
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