Question

Define increasing returns to scale and explain briefly with graphical illustration why it is cost-effective to expand production if a firm’s production function exhibits increasing returns to scale

Answer 1

Increasing returns to scale occurs when an increase in inputs leads to a more than proportionate increase in output.

That is, if inputs increase by 10 times, then output will increase by say 15 times.

It is a point of profit making for the firm, since increase in output is more than increase in inputs.

Graphically, it is represented as below:

IRS Curve Total Product X O 1L+1K 2L+2K 3L+3K Unit of Labour and Capital

It is cost effective to expand production if a firm is experiencing increasing returns to scale because it means the firm is experiencing profits since its increase in cost incurred while increasing inputs is less than the money it makes when its its output increases more than the proportionate Increase in inputs. That is, at this point, increase in revenue from selling increased output (Marginal revenue) is greater than increase in cost from employing more inputs (Marginal cost), which is a point of profit making for the firm. As a result, firm must continue production and expansion at this stage.