If a firm had everywhere increasing returns to scale, what would happen to its profits if prices

step 1 Okay, so we are going to be doing an analysis of returns to scale. Okay, so we are given a coupl

If a firm had everywhere increasing returns to scale, what...

Key Concepts

Increasing Returns to Scale

This concept refers to a production scenario where increasing the input by a certain factor leads to a more than proportional increase in output. When a firm experiences increasing returns to scale, its cost per unit of output decreases as it expands its scale of operation, which indicates that it is operating more efficiently at larger scales.

Fixed Prices

This refers to a market condition in which the prices of goods and services remain constant regardless of changes in the quantity produced or consumed. In such a scenario, the revenue generated is directly proportional to the amount of output sold, as price fluctuations do not affect the firm’s income.

Profit Implications in the Context of Scale Expansion

Under fixed prices, if a firm with increasing returns to scale doubles its scale of operation, it can produce more than double the output while the total costs do not increase proportionally. This results in a reduction in average costs, thereby enhancing the profit margins since the revenue (being a multiple of the independent price) increases more than the costs.

Transcript

00:01 Okay, so we are going to be doing an analysis of returns to scale.

00:12 Okay, so we are given a couple of scenarios that would need to analyze, but first we just want to find out what this means.

00:22 Now, ordinarily by definition, returns to scale would refer to the proportion between the increase in total input and the resulting increase in output.

00:33 So we are looking at total input on one hand versus total output.

00:48 Okay, so that's basically what we would be looking at in this analysis.

00:56 So one of the things that would also try to explain in a different light is when we're looking at the inputs and output, right? it is simply the issue of average costs.

01:16 Okay.

01:18 So if average costs are decreasing as a result of an increase in the operations of the firm, okay? so we normally find that they follow decreasing marginal returns, decreasing, returns to scale as the business continues to expand these operations up until a certain point when these operations would tend to yield negative returns.

01:57 Okay, but ideally one can understand that in a typical firm, we're looking at the average cost.

02:08 We can have average cost one.

02:11 Average cost two average cost curve three average cost curve three average cost curve four average cost curve five okay so typically in the long run okay so these are short run average cost curves just indicating what happens as a result of expansion of business activities so if you are to combine this okay, so you come up with the long run average cost curve.

03:07 Okay, so basically if the prices are fixed, okay, let's have the green arrow to just show us the price.

03:19 Okay, so we have the revenue costs.

03:27 Maybe if we can ideally put the price.

03:37 Okay.

03:37 So you notice if the price is fixed, for instance, at this level.

03:48 What it simply means that obviously the, if the firm is operating at ac1, okay? it simply means that it's incurring losses and obviously this is not an ideal place for a firm to be.

04:08 But thankfully, if it expands its operation, to this short -run average cost two, if it expands its operations, you will notice that the profitability of the firm will obviously start increasing and therefore you will notice that because the average costs are decreasing, this point between the average cost curve 1 and average cost curve 3 is generally where we experience increasing returns to scale.

04:58 Okay, so the returns to scale are increasing.

05:02 But after this point, you'll notice these are decreasing returns to scale...

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