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Assigment 3

1. The document discusses determining returns to scale for various production functions. Constant returns to scale occur when a 1% increase in all inputs leads to a 1% increase in output. Increasing returns occur when output increases by a higher percentage than the input increase. Decreasing returns occur when the output increase is less than the input increase. 2. The document also examines a Cobb-Douglas production function estimated for a metal sheet company. It determines that a 1% decrease in labor hours would lead to a 0.4% decrease in output. A 5% reduction in machine hours and energy input would lead to a 3% decrease in output, holding labor constant. 3. Returns to scale for the C

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168 views4 pages

Assigment 3

1. The document discusses determining returns to scale for various production functions. Constant returns to scale occur when a 1% increase in all inputs leads to a 1% increase in output. Increasing returns occur when output increases by a higher percentage than the input increase. Decreasing returns occur when the output increase is less than the input increase. 2. The document also examines a Cobb-Douglas production function estimated for a metal sheet company. It determines that a 1% decrease in labor hours would lead to a 0.4% decrease in output. A 5% reduction in machine hours and energy input would lead to a 3% decrease in output, holding labor constant. 3. Returns to scale for the C

Uploaded by

anita teshome
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Assigment 3

1. Determine whether the following production functions exhibit constant, increasing,


or decreasing returns to scale.

A. Q = 0.5X + 2Y + 40Z

B. Q = 3L + 10K + 500

C. Q = 4A + 6B + 8AB

D. 𝑄 = 7𝐿2 + 5𝐿𝐾 + 2𝐾 2

E. 𝑄 = 10𝐿0.5 𝐾 0.3

2. Suppose the production Function of Adama metal sheet company is estimated as


follows:

𝑸 = 𝒃𝒐𝑳𝑏1 𝑲𝑏2 𝑬𝑏3

Where

Q = output

L = labor input in worker hours

K = capital input in machine hours

E = energy input in

Each of the parameters of this model was estimated by regression analysis

using monthly data over a recent 3-year period. Coefficient estimation

results were as follows:

ˆb0 = 0.9; ˆb1 = 0.4; ˆb2 = 0.4; ˆb3 = 0.2

The standard error estimates for each coefficient are

ˆb0 = 0.6; ˆb1 = 0.1; ˆb2 = 0.2; ˆb3 = 0.1

A. Estimate the effect on output of a 1% decline in worker hours (holding K and E


constant).

B. Estimate the effect on output of a 5% reduction in machine hours

availability accompanied by a 5% decline in energy input (holding L constant).


C. Estimate the returns to scale for this production system.

Q1, Solution

A. To determine Initially
X = 50
Y = 75
Z = 100
𝑄 = 0.5𝑋 + 2𝑌 + 40𝑍, 𝑄 = 0.5(50) + 2(75) + 40(100) = 4,175

Increasing all inputs by an arbitrary percentage 2%

𝑄 = 0.5(51) + 2(76.5) + 40(102) = 4,258.5

𝑄2
(𝑄1 = 4175/4258.5 = 1.02), the output elasticity is 1 and the production system

exhibits.Increasing returns to scale

B. let L = 50
K = 100
𝑄 = 3𝐿 + 10𝐾 + 500
𝑄 = 3(50) + 10(100) + 500 = 1,650

Increasing both inputs by an arbitrary percentage 3% 𝑄 = 3(51.5) + 10(103) +


500 = 1,684.5

𝑄2
( = 1,684.5/1,650 = 1.021), the output elasticity is less than 1 and the
𝑄1

production system exhibits Diminishing returns to scale.

C. let A = B = 100 𝑄 = 4𝐴 + 6𝐵 + 8𝐴𝐵, 𝑄 = 4(100) + 6(100) + 8(100)(100) =


81,000 Increasing both inputs by an arbitrary percentage 1% 𝑄 = 4(101) +
𝑄2 82,618
6(101) + 8(101) (101) = 82,618 (𝑄1 = 81,000 = 1.02), the output elasticity is

greater than 1 and the production system exhibits Increasing returns to scale
D. Q = 7L² + 5LK + 2K²
its power production function. Returns to scale are calculated by summing the
exponents of the power function or, alternatively, by summing the log-linear
model coefficient estimates.
lnQ=ln5+2lnL+ln2+2lnK = a+b = 2+2= 4 Increasing returns to scale
E. 𝑄 = 10𝐿0.5 K0.3
Summing the coefficients =0.5+0.3 = 0.8
Which is ≤ 1 it indicates Decreasing returns to scale

Q2, Solution

A. For Cobb-Douglas production functions, calculations of the elasticity of output with


respectto individual inputs can be made by simply referring to the exponents of the
production

relation. Here a 1% decline in L, holding all else equal, will lead to a 0.4% decline in
output.

∆𝑄 𝑏1 −1 𝑏1 −1+1
𝑄 ∆𝑄 𝐿 (𝑏0 𝑏1 𝐿 𝐾𝑏2 𝐸 3 )×𝐿 𝑏0 𝑏1 𝐿 𝐾𝑏2 𝐸 3
Notice that: ∆𝐿 = ∆𝐿
×𝑄 𝑄
= 𝑏1 = 𝒃𝟏
𝐿 𝑏0 𝐿 𝐾𝑏2 𝐸 3

Because (∆Q/Q)/(∆L/L) is the percent change in Q due to a 1% change in L,

∆𝑄
𝑄 ∆𝑄 ∆𝐿 ∆𝑄
∆𝐿 = 𝑏1 = = 𝑏1 × = 0.4 × (−0.01) = −𝟎. 𝟎𝟎𝟒 𝑶𝒓 − 𝟎. 𝟒%
𝑄 𝐿 𝑄
𝐿

B. From part A it is obvious that:


∆𝑄 ∆𝐾 ∆𝐸
= 𝑄 = 𝑏2 ( 𝐾 ) + 𝑏3 ( 𝐸 ) So, coefficient estimation results of b2=0.4 and b3=0.2 were

given and 5% reduction in machine hours and 5% decline in energy input holding
labor (L) constant.

= 0.4(−0.05) + 0.2(−0.05)

∆𝑄
= −𝟎. 𝟎𝟑 𝐨𝐫 − 𝟑%
𝑄

C. In the case of Cobb-Douglas production functions, returns to scale are determined


by simply summing exponents because:
𝑄 = 𝑏0 𝐿𝑏1 𝐾 𝑏2 𝐸 𝑏3 ℎ𝑄 = 𝑏𝑂 (𝐾𝐿)𝑏1 𝑏1 (𝐾𝐾)𝑏2 (𝐾𝐸)𝑏3

𝐾 𝑏1+𝑏2+𝑏3 𝑏0 𝐿𝑏1 𝐾 𝑏2 𝐸 3

𝐾 𝑏1+𝑏2+𝑏3 𝑄
Here 𝒃𝟏 + 𝒃𝟐 + 𝒃𝟑 = 𝟎. 𝟒 + 𝟎. 𝟒 + 𝟎. 𝟐 = 𝟏

It indicates constant returns to scale. This means that a 1% increase in all inputs will
lead to a 1% increase in output, and average costs will remain constant as output
increases.

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