Law of returns to scale examines the input-output relation when all the inputs are changed simultaneously in the same ratio. When a business firm grows in size or increase the scale of operations it can derive production advantages from market and firm size in terms of low average cost of production. Such production advantages due to large scale operations are known as economies of scale. It is present when an increase in output causes long run average cost to fall. The fall in cost of production (average) is because of increased productivity resulting from specialization in areas like production, marketing, research and development, management etc.
The economies of large scale operations can be classified into internal economies and external economies. The features and types of internal economies are briefly explained below.
Internal economies are those economies which accrue to a single firm due to its increase in scale of operations. The source of internal economies to a large firm is from the use of more efficient production methods and efficient management of resources. The different kinds of internal economies are noted below:
- Technical economies: this arises out of most modern production technology which can reduce the cost of production per unit. A large firm, as it increases production can make use of the optimum utilization of plant and machinery. A large firm can afford to make use of the most modern technologies while a small firm must satisfy with the primitive technologies.
- Economy of labor: in a large firm, division of labor is much more specialized than small firms. This increases the efficiency. As the number of employees in a small firm are less, an employee has to perform many tasks and it makes him jack of all trades but master of none. Furthermore he losses much of his time in moving from one task to another.