A Project on

Expansion Path and Returns to Scale

Submitted By- Saurav Upadhyay (B.A LL. B Semester- 1)

Submitted To- Mr. Hari Chand

1
Acknowledgement

This assignment would not have been possible without the support of many people.
I wish to express my gratitude to my subject teacher, Mr. Hari Chand, who was
abundantly helpful and offered invaluable assistance, support and guidance. His
teaching made me competent enough to tackle this assignment with such
efficiency. I would also like to thank the hon’ble Vice Chancellor of the
University, Dr. Nishtha Jaswal, for providing us with this opportunity for learning
and the platform to exhibit our knowledge of the subject. Deepest gratitude is also
due to the faculty and members of Himachal Pradesh National Law University;
without whose knowledge and assistance this assignment would not have been
successful. Special thanks also to all my friends, for sharing the knowledge and
invaluable assistance.

2
Table of Contents

TITLE PAGE

INTRODUCTION 4

AIM 5

RESEARCH METHODOLGY 5

THEORY OF PRODUCTION 6

RETURNS TO SCALE 10

EXPANSION PATH 18

BIBLOGRAPHY 20

WEBOGRAPHY 20

3
Introduction

Microeconomics is the study of individuals, producers and firms' behavior in

decision making and allocation of resources. It analysis the mechanism by which
different economic units attain the position of equilibrium. Microeconomic study
can be seen as a study of the constant interaction between various individual
groups of customers and producers.
Production is thus a vital part of microeconomics. It deals with the transformation
of physical inputs into physical outputs. In economics, production is not merely
confined to effecting physical transformation in the matter, but the creation or
addition of value.
Returns to Factor is the behavior of production in long run, i.e. when all factors are
varied proportionately. Expansion Path is a curve used in micro economics to
denote minimum cost combinations of a two-factor produce with expansion in the
level of output of the firm.
For a complete understanding of the said concepts, we must explore the Theory of
Production, specifically in the long run with both factors a variable.

4
Aim
The aim of this project is to properly explain the concepts of “returns to scale” and
“expansion path” with the help of illustrations, diagrams and definitions. We will
study the Theory of Production with two variables and correspondingly study
Returns to Scale and Expansion Path along with their various components.

Research Methodology
This research has utilized Doctorial method of research. Data has been gathered
from both offline and online sources at disposal to produce an extensive research
paper on the subject of Returns to Scale and Expansion Path.

5
Theory of Production
Production refers to the act of transferring inputs into outputs. It provides a formal
framework to help the managers of firms in deciding how to combine various
factors or inputs most efficiently to produce the desired output of a product or
service.
The functional relation between the physical inputs and physical output of a firm is
called the Production Function. Thus, the theory of production is the study of
production functions.
Algebraically, production function can be written as:
Q=f (a, b, c, d………)
where q stands for the quantity of output, a, b, c, d etc. stand for quantities of
factors A, B, C, D, etc. respectively. This function shows that there exists a relation
between the quantity of output and the inputs. This unspecified relation is denoted
by the letter f.
For the sake of convenience, we shall limit our input factors to two, labour and
capital, denoted by L and K respectively. This makes the production function:
𝑄 = 𝑓 (𝐿, 𝐾)
In micro economics, we consider two situations in production, each denoted by a
respective production function. These are:
a) Short Run Production Function
In the short run production function, quantity of one input is varied while the
others are set constant. It relates to real life situation of a firm in short run as
factors such as labour and raw materials can be increased or decreased while the
capital, state of technology, land assets, etc. remain fixed.
̅)
𝑄 = 𝑓 (𝐿, 𝐾
b) Long Run Production Function-
In the long run production function, the relationship between input and output is
explained under the condition when both factors, labor and capital, are variable
inputs. In the long run, the supply of both the inputs, labor and capital, is assumed
to be elastic (changes frequently).

6
 𝑞 = 𝑓 (𝐿, 𝐾)
In the long run, the functional relationship between changing scale of inputs and
output is explained under laws of returns to scale. The laws of returns to scale can
be explained with the help of isoquant technique.

Isoquants

Factor Combination Labour Capital

A 1 12
B 2 8
C 3 5
D 4 3
E 5 2

7
Isoquant curve is the locus of various combinations of the two variable factor input
(i.e. labour and capital) which yield the same level of out.
An isoquant represents all those input combinations which are capable of
producing the same level of output. Thus, the isoquants can be defined as the
contour lines which trace the loci of equal outputs. Since an isoquant represent
those combinations of inputs which are capable of producing an equal quantity of
output, the producer would be indifferent to them. Therefore, they are often called
production-indifference curves.

Assumptions-
 Production of commodity involves only two factors.
 Units of each factor input are homogeneous.
 Two inputs are substitutable.
 The production techniques remain fixed.
 Two factor inputs are perfectly divisible.

Marginal Rate of technical Substitution

Marginal rate of technical substitution indicates the rate at which factors can be
substituted at the margin without altering the level of output. Marginal of technical
substitution of labour for capital may be defined as the number of units of capital
which can be replaced by one unit of labour, the level of output remaining
unchanged.

Marginal rate of technical substitution of labour for capital is equal to the ratio of
Marginal physical product of capital and Marginal physical product of labour.

𝑀𝑃𝐾
𝑀𝑅𝑇𝑆𝐿𝐾 =
𝑀𝑃𝐿

8
 Factor Combination Labour Capital MRTS of L for
K
A 1 12 -
B 2 8 4
C 3 5 3
D 4 3 2
E 5 2 1

Properties of MRTS
 Isoquant curve slope negatively.
 Convex to origin.
 Higher the isoquant, higher the level of output.
 Never intersects.

An important characteristic of Marginal Rate of Technical Substitution is that it

diminishes as more of labour is substituted for the capital. In other words, as the
quantity of labour used is increased and the quantity of capital employed is
reduced, the amount of capital that is required to be replaced by an additional unit
of labour so as to keep the output constant will diminish. This is known as
Diminishing Marginal Rate of Technical Substitution.

Now that we have understood isoquant curve and Marginal Rate of Technical
Substitution, we shall now undertake the study of returns to scale.

9
Returns to scale
In long run production function, the two factors or inputs in a particular production
function are proportionately changed. We shall study the change in the output
when all the factors are changed proportionately in long run production function.
In other words, we shall study the behavior of output in response to the changes in
scale.
The scale of production in the context of the two-factor production function means
a given amount of labour and capital used in the production process. An increase in
the scale of production means that all inputs or factors in the given firm is
increased in the same proportion.

In calculating the returns to scale, we calculate the increase in output with the
increase in the scale of production of the firm.
Koutsoyiannis - “The term returns to scale refers to the changes in output as all
factors change by the same proportion.”

We shall explain the concept of returns to scale by assuming that only two factors,
labour and capital, are needed for production for the sake of simplicity and to
effectively utilize isoquants in the study.
Returns to scale can be determined by the function coefficient 𝜀 which is equal to
the ratio between the proportionate change in output and the proportionate change
in input.

10
 ∆𝑞⁄
𝑞
𝜀=
∆𝑖⁄
𝑖

Returns to scale may be constant, increasing or decreasing:

 If 𝜀 > 1
It means that proportionate change in output is greater than proportionate
change in input, which means that the returns to scale are increasing.
 If 𝜀 =1
It means that the output change exactly in the same proportion in which all
factor inputs change. Returns to scale are said to be constant.
 If 𝜀 < 1
It means that proportionate change in output is lesser than proportionate
change in input, which means that the Returns to scale are decreasing.

11
 Increasing returns to scale

Increasing Returns to Scale

Increasing returns to a scale means that the output increases in a greater

proportion than the increase in inputs.
— In the words of Mrs. Joan Robinson, "Increasing Returns to a factor
states that when an increasing amount of a factor of production is employed
it generally brings about an improvement in organization. As a result of it,
units of the factor concerned become more efficient and to increase
production it will not be necessary to increase the physical quantity of the
factor in the same proportion."

In other words, As the proportion of one factor in a combination of factors is

increased, upto a point, the marginal productivity of the factor will increase.
Increasing returns to a scale occur mainly due to economies of large scale.

12
  Indivisibility of the factors-
Many economists are of the view that Indivisibility of the factors cause the
Increasing Returns to Scale. Some factors are large and lumpy and can only
be fully utilized at a large level of output. Therefore, in the case of some
indivisible and lumpy factors, when output is increased from a small level to
a large one, indivisible factors are better utilized and therefore increasing
returns are obtained.

 Specialization of labour and machinery-

Returns to Scale increase with the increase in scale of production due to
greater possibilities of specialization of labour and machinery in case of
larger scale of production.
At a of larger scale of production, instead of being generalists, workers can
specialize in performing a particular task in the production process.
Generally, a worker who does one task repeatedly will do that task more
efficiently than the one who has to perform various tasks. The time of the
work is also saved as he can stick to a single machine instead of changing
them from task to task.

13
 Constant Returns to Scale

Constant Returns to Scale

Constant returns to scale refer to the production situation in which output

increases exactly in the same proportion in which factors of production are
increased. In simple terms, if factors of production are doubled output will
also be doubled.
In mathematics, the case of constant returns to scale is called linear
homogeneous production function or homogeneous production function of
the first degree.
Economists believe that to successfully have constant returns to scale, the
factors must be perfect substitutes. They say that if constant returns to scale
does not prevail in some industries it is because it is not possible to increase
or diminish factors used in them in exactly the same proportion.
They provided two reasons for our inability to vary the factors in the same
proportion.
 Scarcity of some factors inhibit them to be increased in a given proportion.
The scarcities of these factors lead to diminishing returns to scale.
 Indivisibility of certain factors is another reason why they can’t be increased
proportionately. They have to be exploited even at small level of output and
is not increased when required to expand the output since they are not being
fully utilized.

14
 Diminishing Returns to Scale

Diminishing Returns to Scale

Where the proportionate increase in the inputs does not lead to equivalent
increase in output, the output increases at a decreasing rate, the law of
decreasing returns to scale is said to operate. This results in higher average
cost per unit.

Mr. Joan Robinson, defines it in these words: The law of Diminishing

Returns states that with a fixed amount of any one factor of production
successive increase in other factor will after a point yield a diminishing
increment of output"

When a firm goes on expanding by increasing his inputs, eventually

decreasing returns to scale will occur. But amongst the economists there is
no agreement as of the cause of decreasing returns to scale.
Some economists believe that the entrepreneur is a fixed factor of
production, so when all the other factors are increased keeping it constant,
law of variable proportions come into play beyond a point and decreasing
returns to scale is observed.

15
 Others blame the increasing difficulties of management, co-ordination and
control for decreasing returns to scale. When the firm has expanded too
much, it becomes harder to manage as efficiently as before.

Varying Returns to Scale:

In an actual firm, there are three phases of increasing, constant and

decreasing returns to scale in a single production function.
In beginning, when the scale is increased, increasing returns to scale are
obtained because of greater possibilities of specialization of labour and
machinery. After a point, there is a phase of content written to scale where
output increases in the same proportion as input. Empirical evidence
suggests that the phase of content returns to scale is quite long. If the firm
continues to expand, eventually a point will be reached beyond which
decreasing returns to scale will occur due to the mounting difficulties of
coordination and control.

Iso Cost Line

The iso cost line depicts the prices of the factors employed in the in the firm.
The iso cost line is defined as the locus of various combinations of factors which a
firm can buy with a constant outlay. The iso-cost line is also called the price line or
outlay line.
The slope of the isocost line represents the relative prices of the inputs, labor and
capital. When the price of one change relative to the price of the other, the line
does not shift, but the slope changes.
Mathematically, an isocost line can be expressed as:
C = w.L + r.K
And the slope is
Slope = w/r

16
Where,
C = cost of production
w = price of labor or wages
L = units of labor
r = price of capital or interest rate Iso-cost Line

K =units of capital

17
Expansion Path

The expansion path may be defined as the locus of the points of tangency between
the iso product curves (isoquants) and the iso cost lines. According to Leftwich,
Expansion Path is a curve which shoes least cost combinations of inputs
corresponding to different levels of output.

18
 The expansion path is also known as scale line because it shows how the
entrepreneur will change the quantities of the two factors when it increases the
level of output.
The expansion path can have different shapes and slopes depending upon the
relative prices of the productive factors used and the shape of the iso quants.
Since expansion path represents minimum cost combinations for various levels of
output, it shows the cheapest ways of producing each output, given the relative
price of the factors.
Expansion path of the linear homogeneous production function (i.e. production
function with constant returns to scale) is straight line from the origin.
To explain the concept, let us assume a firm with factor prices such that are
represented by slope of the isocost line AB in the figure. The four iso cost lines
AB, CD, EF, GH denotes the multiple options for the firm to produce output as per
its’ total outlay.
If the firm wants to produce output denoted by Q1, it’ll chose the factor
combination E1 which minimizes cost of production; E1 being the point of tangency
between the isoquant Q1 and the iso cost line AB.
Now if it wants to produce a higher output denoted by Q2, it’s chose the factor
combination E2 which is the least cost combination for the new combination.
Likewise, for still higher output denoted by Q3 and Q4, the firm’ ll choose tangency
combination E3 and E4 respectively which minimize the cost for the given outputs.
The line joining the minimum cost combinations E1, E2, E3, E4 is called the
expansion path because it shows how the factor combination with which the firm
produces will alter as the firm expands its level of output.

19
Bibliography

 Production Economics: The Basic Theory of Production

Optimization
 Introductory Micro Economics by Sandeep Garg
 Advanced Microeconomics by KR Gupta
 Advanced Economic Theory: Microeconomic Analysis by HL
Ahuja

Webography

 British Library

 Managerial Economic
http://economicsconcepts.com/managerial_economics.htm

 The Choice of Optimal Expansion Path

http://www.yourarticlelibrary.com/

 How to Show Returns to Scale on an Expansion Path?

http://www.economicsdiscussion.net/

20
21