Saturday, 29 November 2008

Offsetting diminishing returns

My last post on the potentially higher-than-exponential product diversity generated by scientific innovation (which could equally apply to productive process combination) suggests one possible route by which a productive factor might exhibit increasing returns to scale. Usually, it is assumed that factors exhibit diminishing returns through exponential contraction, but if the usual decline is offset by increasing product diversity then eventually the greater-than-exponential growth may dominate.

The argument for declining returns to scale often given is that the factor will have less of the other productive factors with which to work, so the output will fall off. There is enough empirical evidence to support the claim, and it is intuitively clear as well. But increasing product diversity could offset it, indicating that the rationale is not the most fundamental specification of productive interactions. A detailed microfounded production function embedding the two causes would help to clarify the situation and would also suggest as yet unknown influences on returns to scale.

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