1. Your supervisor requests a careful, common-sense definition of increasing ver

Question

1. Your supervisor requests a careful, common-sense definition of increasing versus decreasing returns to scale -- a production-specific concept. She also wonders how increasing and decreasing returns to scale are related to your firm's average cost structure. Explain to help her understand.

2. How are economies of scale different from economies of scope? Provide an example of the difference.

3. A farm equipment firm produces small tractors at an estimated total cost: C = 37,500,000 + 5,000Q + 1.5Q2, where Q denotes annual tractor output. Regional demand for small tractors is given by: P = 30,000 – Q.  

a. Determine the firm’s optimal output and price and its annual profit from tractors.  

b. Because of increased foreign competition, the demand for the firm’s tractors falls permanently to: P = 20,000 – Q. The firm is considering closing its plant immediately. By doing so, it can probably save $18 million of its annual $37.5 million in fixed costs. Alternatively, it can continue to operate the plant for 12 months after which if it shuts down it can walk away from its labor contracts and plant lease and incur no continuing costs. Recommend its most profitable operating strategy and justify.

Explanation / Answer

(1)

Returns to scale relate the increase in output corresponding to an increase in all inputs by the same amount. Specifically, when all inputs are increased by the same proportion (for example, all inputs are increased by N times), if output increases by more than N times, there is increasing returns to scale and if output increases by less than N times, there is decreasing returns to scale.

Returns to scale is related to average cost structure. When the firm is experiencing increasing returns to scale, average cost falls with increase in output, and this range corresponds to the downward sloping part of an U-shaped average cost curve. On the other hand, when the firm is experiencing decreasing returns to scale, average cost rises with increase in output, and this range corresponds to the upward rising part of an U-shaped average cost curve.

NOTE: As per Chegg Answering Policy, first question has been answered.

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