Increasing or Decreasing Returns to Scale

Why is Costco so beloved among middle class families? Because of that bulk pricing, baby!

Bulk pricing is a thing because of increasing returns to scale. Increasing returns to scale is when output grows at a faster rate than inputs in production. For instance, a one-baker bakery might be able to produce 10 baked goods an hour, while a three-baker bakery might be able to produce 40 baked goods an hour.

While the input tripled, going from one baker to three, the output quadrupled.

Increasing returns to scale is the reason larger companies sometimes take over the market share of smaller companies. Often, larger companies can produce more output per input than smaller companies, which means some of those savings can get passed on to consumers, outpricing the smaller businesses (sorry, guys).

The buck does stop somewhere, though. If companies get too big and isn't managing all of those inputs very well, things could easily go down the "decreasing returns to scale" route. Decreasing returns to scale is the opposite of increasing returns to scale, when adding more inputs actually decreases output made per input added.

For instance, if we add five bakers to that bakery, and there’s not enough room and ovens for them all, they are able to produce only 45 goods per hour. That’s only five more baked goods from two more bakers in the kitchen...literally too many cooks in the kitchen. Something’s gotta give if the additional output isn’t worth the additional input.