Returns to Scale

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Returns to Scale

Returns to scale is a concept that tries to explain the behaviour of the output in relation to the change in the total scale of operations of the firm. A change of scale of operations means a change in the total size of the firm, i.e. a change in both labour and capital of the firm. For determining the returns to scale, we need to calculate the Output Elasticity where: Output Elasticity = % change in Output/% change in all inputs

The different types of returns to scales are:
a)Increasing Returns to scale: Here the % change in the output is higher than the % change in Inputs. In other words, the Output Elasticity is greater than 1.

b)Constant Returns to Scale: This occurs when the % change in the output is equal to the % change in Inputs. In other words, the Output Elasticity is equal to 1.

c)Decreasing Returns to Scale: It happens when the % change in the output is lower than the % change in Inputs. In other words, the Output Elasticity is less than 1.

In this assignment, we studied the four major companies of the Information Technology industry in terms of their cost of goods sold, their capital expenditure and their labour expenditure for the past 10 years. After that we ran a regression test so as to find out if the industry has received increasing or decreasing or negative returns to scale. Cobb-Douglas production function

Q= a*(L^b)*(K*c)
where Q= output, L= labour, K= Capital and b+c= 1
and if b+c=1…… Constant returns to scale
b+c>1……………..Increasing returns to scale
b+c
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