Question

The Data of Macroeconomics - End of Chapter Problem If a 10 percent increase in both capital and labor causes output to increase by less than 10 percent, the production function is said to exhibit decreasing returns to scale. If it causes output to increase by more than 10 percent, the production function is said to exhibit increasing returns to scale. Why might a production function exhibit decreasing or increasing returns to scale? Consider the three different scenarios (A, B, and C) described below. Place each scenario letter (A, B, or C) into the proper category, as most likely to exhibit either increasing or decreasing returns to scale in production. Scenario A: A small economy has many unemployed workers and much unused capital. However, the unemployed workers have less work experience and education than those currently working. An increase in demand for this nation's output causes all firms in the economy to hire 10% more workers and lease 10% more capital. Scenario B: A developing national economy currently employs a small percentage of its available labor force and capital. Increased global demand for the output of this nation's economy requires its firms to employ 10% more labor and 10% more capital. This change allows firms to try new and novel combinations of labor and capital in their production processes. Scenario C: A small island nation's economy consists solely of commercial fishing firms. These firms currently employ modest boats manned by small crews to efficiently harvest all of the 10 mile off-shore perimeter of the nation's sovereign ocean waters. Each day, these boats go out to sea and return to the island to deliver their catch to buyers. A new treaty expands this legal fishing area to a 20 mile off-shore perimeter. The firms respond by employing 10% more boats and 10% more crews to exploit this new opportunity. Increasing Returns to Scale Decreasing Returns to Scale

Answer 1

If increasing all inputs by N%, output increases by more than (less than) N%, there are increasing (decreasing) returns to scale.

Therefore:

Increasing returns to scale:

- Scenario B [Reason: New production methods may increase efficiency of both inputs]

Decreasing returns to scale:

- Scenario A [Reason: Unemployed workers have less experience, so will not be as productive as those already working]

- Scenario C [Reason: Doubling the fishing perimeter does not enable catching of more than double the amount of fish]