Question

(a) List four reasons why a firm might experience increasing returns to scale (or economies of scale).

(b) A firm has the following production function, where Q is output, L is labor and K is physical capital:

Q = 30K0.5L0.7

Is this firm operating under increasing, constant, or diminishing returns to scale, and why?

Answer 1

a) An increasing return to scale occurs when the output increases by a larger proportion than the increase in inputs during the production process. A firm might experience increasing returns to scale because of

1) Division of labor. If there is a division of labor then there will be more efficiency and hence increasing returns to scale.

2) Innovation. innovation also gives rise to increasing returns to scale.

3) Economies due to larger production will also result in increasing returns to scale.

4) Indivisibility of Factors of Production. One of the Main Reasons which Give Rise to the Law of Increasing Returns is the Indivisibility of Lumpiness of Factors of Production.

b) Q= 30K^0.5L^0.7

This will exhibit increasing return to scale as when we increase K and L x times the overall production increase more than x times.

=  30(xK)^0.5 (xL)^0.7

⁼ 30K^0.5L^0.7 (x)^0.7+0.5

⁼ 30K^0.5L^0.7 (x)^1.2

So the production increases more than x times which is x^1.2. There is increasing returns to scale.