Question

3. If a 10 percent increase in both capital and labor causes output to increase by less than 10 percent, the production function is said to exhibit decreas- ing returns to scale. If it causes output to increase by more than 10 percent, the production func- tion is said to exhibit increasing returns to scale. Why might a production function exhibit decreasing or increasing returns to scale?

Answer 1

A production function may have increasing returns to scale or decreasing returns to scale, or both.

Reasons are as below:

Allocative efficiency: Factors of production (land, labor, capital, and organization) can’t be increased in the short-run. Therefore, returns depend on how these factors are used – Specialized utilization of these factors give increasing returns; otherwise there must be decreasing returns.

Example: Suppose for a manual work, the increasing labor increases production; but they must be provided room for doing work; in the short-run if the company has only one room, the company can deploy 5 workers in maximum for avoiding congestion and increasing returns; anything above that limit there would be decreasing returns. In the short-run the number of rooms can’t be increased because of capital inadequacy.