Theory of —Returns In chapter 13, a study of the behaviour of production, when only one factor was variable and the other factors remain constant, was attempted. That signified the returns to factor. The law of variable proportions was connected with returns to factor. It is the description of a short run production function. In the long run, no productive factor remains constant. All the factor inputs are capable of change. [fll the factor inputs change in a given proportion, how the output yndergoes change, that describes the retums to scale. In this chapter, a study of long run production function or returns to scale will be attempted. 15.1 RETURNSTO SCALE Some factor inputs, in the case of a short run production function, remain fixed, while one factor input can be varied. The change in output, in response to a change in the quantity of variable factor, signifies the returns to factor. In case of the retums to factor, changes continue to take place in the factor proportions, if different levels of output have to be achieved. On the other hand, no factor input is fixed in the long run. As all the factor inputs are varied in a given proportion, how the output changes that signifies the return to scale. If all the factors are increased in the same proportion, that means the scale of production has increased. Suppose a producer employs 20 hectares of land, 10 workers and 4 machines. This factor combination yields some output. Suppose further that all these inputs are doubled, it implies an expansion in the scale of output. In this situation, the way in which output will increase will signify the returns to scale, In the words of Liebhafsky. “Returns to scale relates to the behaviour of total output as all inputs are varied” 1, A Koutsoyiannis : Modern Microeconomics (1979), P77, Production to Scale According to Koutsoyiannis, “The term returns to scale refers to the changes in output as all factors change by the same proportion.”! Suppose there are two factor inputs, labour (L) and capital (K), the production function is expressed as Q =f, K) where Qo is the original level of output. If L and K are increased in a given proportion a, then the production increases to Q,, signifying the returns to scale and the production function is given as Qi = S(@L, aK) If L and K are both doubled, there can be different possibilities. The output may get more than doubled, get exactly doubled, or get less than doubled. The returns to scale in these cases are said to be increasing, constant and diminishing respectively. The returns to scale can be distinguished from he returns to factor with the help of Fig. 15.1 258 © scanned with OKEN ScannerTHEORY OF PRODUCTIONRETURNS TO SCALE 15.1, labour is measured along the horizontal scale and capital is measured along the vertical scale. The map of isoquants, comprised of the curves Q (100), Q (200), Q (300) and Q (400) is given, If input of capital is fixed at Ko and the input of labour can be varied, the output levels 100, 200, 300 and 400 can be achieved by employing Ly, La, Ly and Ly of labour inputs respectively. It signifies the returns to factor. Along the horizontal line KoKp, as input of capital is fixed but the input of labour is increased, the factor proportions continue to change. Similarly along the vertical line LoL.g, input of labour is fixed but that of capital increases and the higher levels of ‘output can be achieved. It again denotes returns to factor. The factor proportions along this line also undergoes changes. The lines OR and OS through origin are the scale lines, Along these lines, the higher levels of output are achieved by increasing the inputs of both labour and capital at the points A, Ay, ‘Az and As. Along the scale line OS through the origin, higher levels of output are achieved by increasing the inputs of both labour and capital, The scale line OR and OS indicate an expansion in the scale of output but the factor proportion along a given scale line, remains constant. The increase in production along, the scale line represents the returns to scale, ‘The returns to scale can be determined through the function co-efficient (e). The function co-efficient is defined as a ratio of proportionate change in output to the proportionate change in all the factor inputs. Function Co-efficient (e) Proportionate Change in Output ~Proportionate Change in All Inputs where Q = Output and Ife> 1, it means the proportionate change in output is more than the proportionate change in all i implies that returns to scale are increasing, t signifies that output changes exactly in the same proportion in which all the factor inputs change. In such a situation, the returns to scale are constant. If <1, the proportionate change in output is less than the proportionate change in all the factor inputs so that the returns to scale are decreasing, QQ 8 = All factor inputs. 152 INCREASING RETURNS TO SCALE ‘The returrs to scale in the case of a long run production function may be increasing, constant and decreasinig. The returns to scale are said to be increasing, when an increase in the inputs of all the 259 factors in a given proportion leads to an increase in output ina greater proportion, Suppose all the factor inputs have been increased by 100 percent but the consequent rise in output is by 120 percent, the returns to scale are increasing. The increasing returns to scale can be depicted through Fig. 15.2. Mi CAPITAL LABOUR x Fig. 15.2 In Fig. 15.2, OR is the scale line passing through origin, Q (100), Q (200) and Q (300) are the isoquants representing the output levels of 100, 200 and 300 respectively. Since OA > AB > BC, it means the proportionate change in output is more than the proportionate change in the inputs of labour and capital, The returns to scale are, therefore, increasing in this case. ‘The increasing returns to scale can prevail in production at least in the initial stages of the expansion of a firm. The increasing returns to scale may exist on account of the reasons given below : (9 Factor indivisibilities : The process of production may involve some productive inputs such as a machine or managerial skill which are indivisible or lumpy. For instance, one half of a turbine or one half of manager can not be employed in production. When production has to be expanded, whole of the indivisible factor unit will have to be used. Since with an increase in the scale of production, these technical and managerial units that are indivisible are utilised in a more efficient manner, the increasing returns to scale appear. Many economists like Kaldor, Joan Robinson, Knight and Lerner hold the belief that increasing returns to scale arise on account of the use of indivisible factor units in production, (i) Greater degree of specialisation = Chamiberline ascribed the increasing retums to greater degree of specialisation of labour, machinery and © scanned with OKEN Scanner260 cement with an increase in the scale of Fragtion, As a consequence, the productivity per nit increases and rise in output is more than proportionate relative to the increase in inputs of these factors: it) Dimensional economies ; The increasing returns to scale may prevail, according to Baumol, on account of the dimensional economy. Suppose the size ofa warehouse is increased from (10" * 10") to (20'x 20) ice, doubled, the area or storage capacity of the warehouse gets more than doubled. It increases by 4 times from 100 sq. ft. to 400 sq. ft. Similarly, ifthe diameter of waterpipe is doubled, the flow of water gets more than doubled, Thus the dimensional relationship can explain why the proportionate change in output can be more than proportionate, when the factor inputs change in a given proportion. 15.3 CONSTANT RETURNS TO SCALE The returns are scale are said to be constant, when with an increase in factor inputs in a given proportion, the output also increases exactly in the same proportion. Suppose all the factor inputs have been doubled and the output also gets exactly doubled, the returns to scale are constant. A production function in case of which the returns to scale are constant is termed a linear homogeneous production function or the homogeneous production function of the first degree. Several economists including Kaldor, Joan Robinson, Lerner and Knight hold the view that constant returns to scale become applicable in production if two conditions are fulfilled. Firstly, there should be perfect divisibility of factors. Secondly, it is possible to vary the productive factors exactly in the same proportion. This viewpoint was, however, controverted by Chamberlin, According to him, even if all productive factors are capable of being varied exactly in a specific proportion and these are perfectly divisible, still production may not be governed by constant returns to scale on account of greater specialisation of labour, technology and managerial skill, dimensional economies and the impact of expansion of skill on the factor efficiency. The empirical evidence has also suggested that the production function for an individual firm and the economic system on the whole follows, to 2 considerable extent, the constant returns to scale. The constant returns to scale can be explained MICRO-ECONOMIC THEORY the help of Fig, 15,3. CAPITAL o LABOUR % Fig, 15.3 In Fig. 15.3, Q (100), Q (200) and Q (300) are the isoquants representing the output levels 100, 200 and 300 units respectively. OR is the scale line. If OA = ‘AB = BC, it implies that the increase in labour and capital inputs in a given proportion leads to an increase in output also in exactly the same proportion and there are constant returns to scale operating in production. 15.4 DECREASING RETURNS TO SCALE The returns to scale are said to be decreasing, when the increase in inputs of all the productive factors takes place in a given proportion but the resultant increase in output takes place less than proportionately. Suppose inputs of both labour and capital are increased by 100 percent but the output rises by less than 100 percent, the returns to scale are decreasing, Some economists hold the view that proportionate changes between factor inputs and output cannot take place on account of the fixity of entrepreneurs. Even if it is supposed that other factors can be varied in a given proportion, it is difficult to vary the input of entrepreneurs. It may result in the diminishing returns to scale. In addition, as the scale of production is enlarged, the problems can arise in management, co-ordination and control. That may set in the diminishing returns to scale. The decreasing returns to scale can be explained through Fig, 15. In Fig. 15.4, Q (100), Q (200) and Q (300) are the isoquants representing the output levels 100, 200 and 300 respectively. If OA < AB < BC, it indicates that the proportion in which output increases is less than the proportion in which the inputs of labour and capital are increased. In such a situation, the returns to scale are decreasing. © scanned with OKEN ScannerIMEORY OF PRODUGHOH- BC, After the point C, with the increase in scale of production, constant return to scale become available upto the point E “ D = DE. After the point E, as there is further expansion in the scale of output, the decreasing Felurns to scale become applicable because EF < FG. In this way, firin actually has the varying returns to scale as it continues to expand the scale of output 156 CONSISTENCY OF DIMINISHING RETURNS TO FACTOR WITH VARYING RETURNS TO SCALE According to the law of variable proportions, if the inputs of other factors remain fixed and input of only one factor (say labour) is increased, the marginal return of the variable factor must eventually decrease Since a typical business firm operates only in the second stage of the law in which the marginal return of the variable factor diminishes, it signifies that the return to factor bs always diminishing, ‘The returns to scale, on the other hand, re to the way in which output changes, when all the factor inputs are increased in a given proportion. The returns to scale may be increasing, constant or decreasing. In other words, the returns to scale are varying, ‘There is some controversy among economists on the issue of consistency of diminishing returns to factor with the varying returns to scale. Some writers have expressed doubt how the returns to factor can be diminishing, when the returns to scale are increasing, constant and decreasing. In fact, there is no contradiction or inconsistency between the diminishing returns to factor and varying returns to scale. They are actually consistent with each other and can co-exist. This is discussed as under : () Consistency of Increasing Returns to Seale and Diminishing Return to Factor Itis possible that the returns to scale are increasing and, at the same time, the returns to factor are decreasing. This can be explained through Fig. 15.6. In Fig. 15.6, labour is measured along the horizontal scale and capital along the vertical scale. Q and 2 are the isoquants. The output level at the isoquant 20 is twice the output level at the isoquant ©. OR is the scale line, Since OA > AB, the returns © scanned with OKEN ScanneraL tanoun 15.6 to scale are increasing, OL of labour and OK of capital give the point of production A. If labour and capital inputs are doubled, the production can take place at the point C where the output is more than doubled. It signifies the increasing returns to scale. On the other hand, if the input of capital remains fixed at OK but the input of labour is doubled to 21., production takes place at D which lies upon the isoquant Q’. At Q’ the output is less than the output at the isoquant 2Q. It means the total output increases less than proportionately and the return to factor is decreasing, Thus the diminishing returns to factor ‘can co-exist with inereasing returns to scale and they are consistent with each other. ii) Consistency of Constant Returns to Seale and Diminishing Return to Factor Sometimes returns to scale are constant but returns to factor are diminishing, The question in this connection arises whether there is consistency between them or not. In this regard, it may be pointed out that the returns to scale may be constant, yet the returns to factor may be diminishing. This can be demonstrated through Fig, 15.7. ° L 2c LAsouR ‘ak Fig. 15.7 In Fig. 15.7, OR is the scale line. Q and 2 the isoquants. Ail the factor combinations of isbour and capital on 2Q yield the ouptut twice the output MONON CONAN, 1H jolded by the factor cory, }. Since OA = AB the rantions Original factor inputs 1, and ye of output at A. HE factor inputs 92l4 # certain level 2k, the OUtput A POINE His tying eee to 21 an now the input of labour is doubled yy 94 42M a A. IF of capital remains fixed ay 4 bathe ingur sented by the oon the isonuann fe Constant, ! at he, tte inoquant 20. Thus even though input op ee doubled, input of capital remaining unc output increases less than proportionee signifies that the returns to factor are dienini Hence there is consistency between the co returns to scale and decreasing returns to fect (ili) Consistency of Decreasing Returns to Seate and diminishing Return to Factor It is also possible that the return to a decreasing and at the same time, returns to facr too are decreasing, The consistency of decrea: returns to scale and the decreasing returns to & can be shown with the help of Fig. 15.4. . tC % tseouR Fig. 15.8 _In Fig, 15.8, OR is the scale line. Q and 20 the isoquants. Each point on 2Q represents an o: twice the output at any point on the isoquant Q. OA 1, the production is governed by increasing By deescale. If <1, the production is governed by decreasing returns to scale. 1f7= |. the Production linge vpined by constant returns to scale, Thus the production. ‘The linear homogeneous production function can be represented graphically through Fig. 15.19 y cu LaBouR Fig. 15.19 In Fig. 15.9, the isoquants Q(100) and Q(200) are given, If scale line is OR, initially L units of capital and K units of capital yield an output of 100 units at A. If both the factor inputs are doubled to 2L units of labour and 2K units of capital, the firm can secure an output of 200 units at B. Since the factor inputs and output increase in the same proportion, the returns to scale are constant. It signifies a linear or first degree homogeneous production function. If the scale line is OS, given the two isoquants doubling of the input of labour from L’ to 2L" and that of, capital from K’ to 2K" results in the doubling of output, from 100 to 200 units at the points A, and By respectively. This again shows that the returns to scale are constant and the production function is linear homogeneous. © scanned with OKEN Scanner272 Properties of Linear Homogenoo Production Function ‘Some important properties of the linear homogeneous production function are as follows : 1. A linear or first degree homogeneous production function shows constant returns to scales This can be proved as under : Q=/KD Multiplying on both sides by the constant 2 IQ = fOK,AL) 2Q = MK 2Q = 1Q Thus when both the inputs K and L rise in the proportion 2, output (Q) also rises in the same proportion (A). In this way, the production is governed by constant return to scale 2. The linear homogeneous production function can be stated in either of the forms. uff) x) This can be proved as below : SOL 2K) = I(LK) oD) 1 , then substituting in (i) Q= or a= t x) = Lfk) s(t) = Tsk) u(t) = fi.) or u(§) = f.K)=Q K) co arction or & r (. t] isa function of € only} Similarly, let 4 = —., then substituting in (/) K 1 xe MICRO-ECONOMIC THEORY S(L,K) we") = flak) ie : ') = fl.K)= z a x (ez 1) is a function of only} kK L Hence Q = f(L.K)= AE} «A(e] 3, The average product of either input (L or K) depends upon the ratio of two inputs irrespective of the absolute magnitudes of the inputs. Let Q =f (L, K) is a linear homogeneous production function. 1 Multiplying on both sides by 77 2 - tiLw 2 tuts) 2 Ae) o APL = A) Itmeans the AP, is the function of capital-labour ratio (K/L) alone irrespective of the absolute magnitudes of K and L. Taking again Q = f(L,K) Multiplying on both sides by E 1 “ = (fbn 1 x RIO RIO ZIO or > 5 A © scanned with OKEN ScannerTHEORY OF PRODUCTION—RETURNS TO SCALE It signifies that AP is the function of labour- capital ratio (reciprocal of eapital-labour ratio) alone irrespective of the absolute magnitudes of K and L. gis The marginal product of either input (L or X) depends upon the ratio of two inputs irrespective of the absolute magnitudes of the two inputs. Taking the linear homogeneous production function of the form K = i(% Q At Taking partial derivative of Q with respect to L -3l() = ERE} = (yee) «om Ey) It signifies that the MP, is the function of capital- labour ratio (K/L) irrespective of the absolute magnitudes of K and L, Taking the linear homogeneous production function again of the form K ~us(k @ a ‘ } Taking partial derivative of Q with respect to K 2 al) i ABM 2. {*) wn ft ifies that the MPx is the function of ‘apital-labour ratio (K/L) irrespective of the absolute magnitudes of K and L. 5. Euler’s theorem holds for the linear homogeneous production function. The Euler's 273 theorem states that the sum of the factor payments, when each factor is paid a price just equal to its marginal product, exhausts the total product. It can be expressed as p22 9Q K.oS+ 72 “OK =o aQ aQ a where 3¢ and 5; are the marginal products of capital and labour respectively. a vw 32 - ¢(K) OO kk K me at, eee Substituting in equation (ii), we have ‘olete]-° {Ebene uf AE Q © Q=Q Thus Euler’s theorem holds true in the case of a linear homogeneous production function. Importance : From analytical and practical points of view, a linear homogeneous production function has immense significance. Firstly, this production function has highly useful characteristics and Properties such as constant returns to scale and is rightly termed as a “well-behaved” production function. Secondly, this production function can be casily handled. It can be used quite easily in computers for making required calculations. Consequently, there is very extensive use of this production function in linear programming and input- output analysis. Thirdly, economists have placed much reliance upon the linear homogeneous production function in the fields of production, distribution and growth. Fourthly, this production function is also of great help in estimating the shares of different productive factors in the national income It provides support to the well-known generalisation that the share of labour remains constant in the national income over long period. Fifthly, a linear homogeneous production function assumes particular importance, when the technical progress is neutral and it affects the marginal products of the © scanned with OKEN ScannerMICRO-ECONOMIG THEORY Fac} factor inputs in equal proportions. Sixthiy, given @ linear homogeneous production function, entrepreneur is required to find out one optimum f proportion. He is not required to make a review of his decision related to factor proportion with an increase in the level of output so long as the factor prices remain unaltered. Seventhly, this production function has received quite significant empirical support, In a study related to the farm management, attempted by A.M. Khusro in 1964, it could be established that constant returns to scale prevailed in Indian agriculture. In the same way, a number of ‘empirical studies undertaken in Britain and the United States found that a long phase of constant returns to scale existed in several manufacturing industries. 15.12 COBB-DOUGLAS PRODUCTION FUNCTION This production function was developed by ' C.W. Cobb and PH.Douglas, when they published their articles, A Theory of Production, in American Economic Review in 1928. It can be expressed in the following form : Q = AL#KS where Q is output, K is fixed capital, L is labour and A, and are constants. Both ot and are positive but less than unity. In logarithmic terms, the C-D production function can be expressed as LogQ = LogA+aLogL +f Log If (@ + B) = 1, the production is governed by constant return to scale, If («+ B) < 1, itis governed by the decreasing return to scale. If (a + B) > 1, production is governed by increasing return to scale. Properties of Cobb-Douglas Production Function ‘The main properties of C-D Production Function are as follows : 1. This production function specifies that production requires both the inputs. If any of the twe inputs becomes zero, production will also become zero. 2. This is a linear homogeneous production function. Under constant return to scale (c.+ f= 1), if all inputs are multiplied by a constant say, x, the output will also increase x times. : Q = AL*KP xQ = A(eL"&ky xQ = Ax@ Lay Ke xQ = AL*K8 (x4 xP) xQ = XU ALTKE Since a+ 1 xQ x. ALY KP xQ = 30 3. This production function yields diminishing return to each factor Q = ANKE a0 Now MP, = 5p = GAL#TK? 2 F Q ‘Taking the second derivative, 3 = a(a— 1) ‘AL®2 KD. Since (a ~ 1) is negative as 0 = B (B-1) AL* KP2, Since (B — 1) is negative as 0 < B < 1, [B(B-1) AL* KP] < 0. Thus, as K increases, MPx. decreases. Hence C-D proudetion function yields diminishing return to factor. 4, The co-efficients @ and B represent the output elasticity co-efficients of labour and capital respectively. Elasticity of Output in Relation to Labour 20@_ 20 ©) = ti ate a ALK AL*KE (d= ©” SRK 3K'Q 2Q K_BALSKPIxK _ BALK? _ KQ aLtKP Auk 5. The co-efficients « and f represent the © scanned with OKEN Scannerey OF PRODUCTION-RETURNS TO SCALE THEO! relative shares of labour and capital in national income or product. aQ supe! Nie ak Share of Labour in N.1 Q Share of Capital in NL = —G KBAL'K | BAL"KE -p -ALSKP AL®KP 6. The Cobb-Douglas production function is fully correspondant with Euler’s theorem. If output is the function of L and K alone, Euler’s theorem can be stated as a a ~ 1.304420 = La AL™!K8+ KB AL* KH = G@AL* KP +BAL# KB = (a+ B) AL*KP=(a+p)Q Under constant return to scale, (+) = 1. Q= 1*Q Hence C-D production function corresponds fully with Euler's theorem, Q 7. The elasticity of substitution (Es) between ‘two factors K and L of C-D production function, in case of constant returns to scale, is equal to unity. uM c ok me, Es betwe = eS 's between K and L OM L MPy. Now Q = AL*KP a MP, = se = GAL™IKP MP, = 20 paLeKe! Mp, @AL™ IKE K MP, BL 25 ‘i> Purther 's between K and L 8. The expansion path generated by C-p Production function is linear and it passes through the origin, The first order condition for constrained optimisation in case of production function is MRP, MP ~ Pq ~O Given the C-D production function Q = AL*Ke MP, _ @AL™'KB a K Te GARE Sa lo MP BALSK! BL ing (ii) into (i) Ns eeu BEEBE K aK Pe = BLP, or @KPq—-BLP, = 0 (iti) From the equation (iii), it follows that the C-D production function is linear and it passes through the origin, Importance : This production function is extensively employed in theories of production, distribution and economic growth. It is greatly in use also in the fields of input-output accounting and linear programming. Douglas conducted both cross-sectional and time series studies for manufacturing industries in the US.A., Canada, Australia, New Zealand and South Africa in 1947. For the U.S.A., the production function for 1899-1922 period was © scanned with OKEN Scanner r