Example of Production with Increasing Returns to Scale

Assumptions:

• Since this is a long run analysis, there is no fixed input. Indeed, for simplicity, there is only one input. Labor is the only input and is variable.
• Our small economy is populated by three people: Bob and John, workers, and Gordon, an entrepreneur (that is, a person who will organize a business if and only if it is profitable to do so).
• • Bob, working alone, can produce output worth 2000 per week.
  • Bob's opportunity cost is 2100 per week. (That means Bob can earn 2100 in producing some other good or service).
• • John, working alone, can produce 2000 per week.
  • John's opportunity cost is 2800 per week.
• If Bob and John work together, thanks to division of labor, they can produce 5500 per week. Suppose, for example, that Gordon sets up a Widget-Tying business and hires Bob and, later, John to do the work. This is an example of "increasing returns to scale" since input increases by 100% when the second worker is hired and output increases by 175% as a result.

Why would output increase more than in proportion to inputs? First, simply having four hands may increase productivity as the two men can simultaneously do different parts of the job. Second, each may concentrate on some part of the work, getting better at it with more practice, but leaving the other part to the other worker who also gains practice and skill in that part. (These were the kinds of advantages Adam Smith particularly stressed). Finally, each may concentrate on the tasks for which he has a greater inborn talent.

Notice that the two-person widget-tying operation uses resources with an opportunity cost of 2800+2100=4900 and produces output worth 5500, for a net increase in production of 600. Evidently, it is a good thing that such a team be organized.