Question

1. (15 pts) a. List four causes of increasing returns to scale (or economies of scale).

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

         Q = 40K^0.5L^0.3

Does this firm operate under increasing or decreasing returns to scale? Why?

c. A firm uses labor and physical capital to make its product. The wage rate is $ 20 an hour and the cost of capital is $ 40 an hour. If the marginal product of labor is 300 units an hour, what must be the marginal product of capital be if the firm is maximizing profit?

Answer 1

a) Causes of increasing returns to scale/economies of scale:

• Specialization of factor of production( division of labour)- In small firms , sometimes a particular worker has to do ample jobs and it is unable to specialize.  Specialization helps to separate tasks and assign particular tasks to workers which have the particular skill-set . This increases the  productivity of the firm and leads to increasing returns to scale ( more than proportionate growth). Also the average output is then produced at lower cost.
• Low resource price:   Large firms can obtain resources at lower costs as they can use the resources more efficiently and can get bulk discounts. They buy resources in large amounts and avail bulk discounts. They have more negotiation power.
• Technological Progress: Efficient and upgraded machines increase productivity of capital.Large firms can afford new technology and can employ such machines and fully utilize them to enhance their growth. They give low cost of production per unit.
• Indivisible factor of production: This means that that labour and capital cannot be divided into fragments. This is responsible for increasing returns to scale.