Economic analysis

Lecture 11
 Laws of production in long-run
(laws of returns and scale)
• These laws are classified as:
i)Increasing return to scale law:
This is witnessed when proportional change in output
is greater than the corresponding proportional
change in inputs.
I Q
2 10
3 20
I increase by 50%  Q increase 100%
 Laws of production in long-run (con.)

ii) Decreasing returns to scale:

This is witnessed when proportional change in
output is less than the proportional change in
inputs.
I Q
2 10
3 12
I increase by 50%  Q increase 20%
 Laws of production in long-run (con.)

iii)Constants return to scale:

Here we have proportional change in output and
input are equal.
Production function and laws of returns to
scale:
Production function is a relationship between
inputs (L) and output (Q) and capital (K).
Q=F(L,K)
 :In case of linear (non power) function

Q=4L+2K  represent constant return to scale

• Assume change in Q is h and input(L,K) change
by k.
• If we have: L=3, K=5 then
Q = 4 + 2 5 = 22
• Alternatively if L=6, K=10 then we have
Q = 4 + 2 10 = 44
 :In case of power equation
Q = L0.6 K0.3
Change in Q= h
Change in input = k
:By substitution
hQ =k0.6 L0.6 K0.3 k0.3
factoring for k we get
hQ =k(0.6+0.3) LK
And (LK) = Q
h= k0.9 h < k , or Q change by less proportion than input.
So the equation represents decreasing returns to scale.
Q = L0.6 K1.2
hQ= k0.6 L0.6 K1.2 k0.3
h= k1.8 h>k
• Q change by greater proportion than input so the
equation represents increasing returns to scale.
Q = L0.6 K0.4
hQ= k0.6 L0.6 K0.4 k0.4
And Q= L0.6 K0.4
h= k0.6 k0.4
h= k
• The least cost combination of input in long-
run:
Here the analysis impose two elements:
1) Isoquant curve.
2) Isocost line.
 Iso quant curve )1
• Iso quant curve shows a certain level of output
which could be realized by a variety of input
combinations (L,K).
Given the following combinations of L and K
:Isoquant curve can be drawn
Units of L Units of K
18 4
14 6
12 10
 Isoquant curve

Characteristics of isoquant are the same as characteristics of IC *

 :Isocost line )2
• This shows the total outlay (expenditure) used to
purchase input (L,K). So Isocost equation is the payment
made for labour plus payment made for capital.
C= QL PL+QKPK
Where:
C = total outlay
QKQL= units of capital and labour being purchased
respectively.
PKPL= per unit price of capital and labour respectively.
 Marginal rate of technical substitution
(MRTS)
• MRTS of L and K denotes the number of units
of capital to sacrifice in order to gain one unit
of labour.
MRTS = slope of Isocost line
 Construction of Isocost
slope = C/PK = /PK

Units of K ) C/PK , 0(

)C/, 0(

Units of L
:How least cost combination is determined

• The least cost combination is attained at the

point of tangency between the Isocost line
and the appropriate Isoquant curve.
• At the least cost combination slope of Isocost
equate with slope of Isoquant curve:

MRTS = /PK = /MPK

The firm is operating efficiently.
 :Next

Economy of scale advantage of large-

.scale production