Question

13. Indicate whether each of the following statements is true or false and give the reason. (a) A firm should stop expanding output after reaching diminishing returns and (b) if large and small firms operate in the same industry, we must have constant returns to scale.

Answer 1

(a) False.

Diminishing returns means that as more of the variable input gets added, additional amount of output produced by one more unit of the input increases at a decreasing rate, that is, marginal product is decreasing. So output increases at a decreasing rate. As long as increase in output is positive, marginal product is positive and the firm should continue increasing output, even if marginal product starts to fall. Firm should stop expansion only when marginal product becomes zero, since increase in output beyond this point will decrease output produced by more inputs, and marginal product will be negative.

(b) False.

If all inputs are increase N times and it results in an increase in output by exactly N times, there is constant returns to scale. Larger firms can exploit economies of scale and therefore they can achieve increasing returns to scale where increase in inputs by N times increases output by more than N times. On the other hands, smaller firms often exhibit diseconomies of scale and therefore they experience decreasing returns to scale where increase in inputs by N times increases output by less than N times. But this cannot be averaged and concluded that there must be constant returns to scale in market.