Question

Suppose that a firm’s production function exhibits increasing returns to scale. Using a suitable diagram, illustrate how a firm’s input choices and costs would vary between producing the whole output at home versus off-shoring a portion of the output to a foreign country that has relatively cheaper labour

Answer 1

Firm’s price output determination when selling products in domestic market and international market under economies of scale.

Economies of scale in production mean that when production at a larger scale, more output can be achieved at a lower cost. In other words output per unit of input increases more than proportionately to the increase in input used. This can be explained in a simple way. Take the case of labour used in the production of steel. The unit of output at any level of production is a function of the level of input used. Consider for producing steel, labour is used.

For producing OQ level of output the firm uses OLs amount of labour. For producing OQ1 output the firm use QLs1 level of output. The area QLsQLS1>QSTQ1. Here the output of steel increases more than proportionately to the increase in input of labour and the firms enjoys the economies of scale.

Before considering the equilibrium of a firm with economies of scale and foreign trade we have to consider the nature of industry. In perfect competition the firm has not tendency to alter its output in shortrun as it gets only a normal profit just to remain in the industry. So under perfect competitive market situation perfect competition exist between the firms and in the factor market. The presence of competition elements never allow the firms to get a profit above the normal. So there is no chance of economies of scale. If a firm adopts a new technology it can reap the benefit of economies of scale. But during shortrun period the technology remain constant.

Under the Monopoly situation the monopolist has no tendency to alter his output. Even if the monopolist gets economies of scale the firm will hide the benefit and reap upnormal profit.

The market situation of monopolistic competition allows the elements of increasing returns or economies of scale. Monopolistic situation is a market where it contains of the elements of monopoly and competition. As the firms sells product which is somewhat differentiated it has control over the cost and output.

In the above figure the firm is in equilibrium with OP price and OQ quantity. As the economies of scale occur it can produce the output at lower cost at OP1 price. The firm is at initial equilibrium with OQ output and OP Price. When the economies of scale operate the falls from OP to OP1 and output increase from OQ to OQ1. This benefit of economies of scale can increase the firms welfare aswell as the consumers welfare in the domestic market.

But when the foreign trade takes place the firm can sell the OQ quantity at the domestic market at OP price and the excess quantity QQ1 it can sell in the foreign market at a lower price OP1. Here the firm has some sort of monopoly power over the product and output as the product is somewhat differentiated from other firms and at the same time the products are close substitutes to the product of other firm.

To sum up a firm under monopolistic competition can reap the benefit of economies of sale when it restrict the output for the domestic market and sell the advantaged quantity to the foreign market.

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