Question

Suppose that the production function y=f(x_1,x_2) (where: y is output level, x_1 is a variable input and x_2 is a fixed input), is plotted in the (y, x_1) space. According to economic theory, we would expect:

a. y to increase with x_1 at a decreasing rate, due to increasing returns to scale.

b. y to increase with x_1 at an increasing rate, due to diminishing returns to scale.

c. y to increase with x_1 at a decreasing rate, due to diminishing returns to scale.

d. y to increase with x_1 at an increasing rate, due to increasing returns to scale.

Please show working!

Thank you!

Answer 1

Correct option is (a).

With one input being fixed, the more the amount of the variable input that is added to production, the less the additional output produced by the last unit of variable input added. Therefore, in this case, as more of X1 gets added to production, output (y) starts increasing at a decreasing rate. As a result, marginal product of X1 starts to decrease with increase in X1. This is called diminishing marginal productivity, which is caused by increasing returns to scale, which refers to the fact that as all inputs get doubled, output increases by less than double.