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It is not economical to produce when a firm is experiencing decreasing returns to scale. A firm that is experiencing decreasing returns will maximize its profits if it cuts back on its size to its minimum efficient scale. The reason for this has to do with average total costs. When a firm is experiencing increasing returns to scale, its average total costs drop as it increases production. Conversely, average total costs increase when the firm is experiencing decreasing returns to scale. Clearly, a firm does not want to increase its average total costs. Instead, it wants to find the point where they are at their minimum. This is the minimum efficient scale.
There are two potential reasons why returns to scale would decrease even if all inputs are increasing. First, it is possible that entrepreneurship might be a limiting factor for the scale of production. In other words, production increases might be based on the genius of an entrepreneur like Steve Jobs. When a firm gets too big, it can exhaust the entrepreneur’s ability to handle it. The entrepreneur can no longer apply his or her talents to the entire firm and returns to scale drop.
Second, and more important, is the increasing complexity of managing a firm as it grows. As a firm grows, the bureaucracy needed to manage it must grow as well. This can decrease the firm’s efficiency. When the firm is relatively small, the people at the top of the firm can have a good grip on what is happening throughout the firm. There will be short lines of communication and chains of command. This will mean that the decision makers can easily understand what is needed and can easily implement any changes that they decide to make. As the firm grows, this is no longer possible. Long bureaucratic chains of command come to stand between top decision makers and the actual production work. This can make it much harder for the executives to know what is needed and for them to implement changes that they decide to make. The added complexity of managing a large firm is the most common reason why returns to scale can decrease even as all inputs are increasing.
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