Neoclassical Characterization of Returns to Scale in Nonparametric Production Analysis

Abstract

From an empirical perspective, this paper critically examines the concepts of returns to scale (RTS) and economies of scale (EOS), and argues that the concept of EOS is more relevant and broader enough to exhibit proper scale economies behavior of firms. Two approaches, i.e., production function and total cost function are available in the literature that are generally taken to be a satisfactory way of empirically verifying scale economies behavior of firms without mentioning whether they are taken exhibit the same causal factors. As argued in this paper that because of the fundamental shortcomings associated with the production function approach where output is narrowly related to the inputs only by defining the input-mix in a special way, the concept of RTS seems to be very restrictive in exhibiting any relevant scale behavior. By exercising prudence in pending more thorough exploration of the sources of scale increases; a strong case is made in this paper supporting the use of a non-parametric cost frontier approach to estimate scale economies behavior.

Keywords: Returns to Scale, Economies of Scale, Data Envelopment Analysis

JEL Classification: C14, C61, D21, D24