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Production
amount of another input to maintain a given level of output. If capital and labor are substitutable, the marginal rate of technical substitution is defined as the ratio of the marginal product of labor to the marginal product of capital, that is, MPL/MPK. Returns to scale refers to the proportional increase in output given an equal proportional increase in all inputs. Since all inputs are variable, “returns to scale” is a long-run production phenomenon. Increasing returns to scale (IRTS) occur when a proportional increase in all inputs results in a more than proportional increase in output. Constant returns to scale (CRTS) occur when a proportional increase in all inputs results in the same proportional increase in output. Decreasing returns to scale (DRTS) occur when a proportional increase in all inputs results in a less than proportional increase in output. Another way to measure returns to scale is the coefficient of output elasticity (eQ), which is defined as the percentage increase (decrease) in output with respect to a percentage increase (decrease) in all inputs. The coefficient of output elasticity is equal to the sum of the output elasticity of labor (eL) and the output elasticity of capital (eK), that is, eQ = eL + eK. IRTS occurs when eQ > 1. CRTS occurs when eQ = 1. DRTS occurs when eQ < 1. The Cobb–Douglas production function is the most popular specification in empirical research. Its appeal is largely the desirable mathematical properties it exhibits, including substitutability between and among inputs, conformity to the law of diminishing returns to a variable input, and returns to scale. The Cobb–Douglas production function has several shortcomings, however, including an inability to show marginal product in stages I and III. Most empirical studies of cost functions use time series accounting data, which present a number of problems. Accounting data, for example, tend to ignore opportunity costs, the effects of changes in inflation, tax rates, social security contributions, labor insurance costs, accounting practices, and so on. There are also other problems associated with the use of accounting data including output heterogeneity and asynchronous timing of costs. Economic theory suggests that short-run total cost as a function of output first increases at an increasing rate, then increases at a decreasing rate. Cubic cost functions exhibit this theoretical relationship, as well as the expected “U-shaped” average total, average variable, and marginal cost curves.
KEY TERMS AND CONCEPTS Average product of capital (APK) The total product per unit of capital usage. It is the total product of capital divided by the total amount of capital employed by the firm.
