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IAI Actuarial Core Principles · Business Economics · Production, costs, revenue and profit in price and output decisions

A Hyderabad insurer finds that doubling all inputs in the long run raises its output by only 80%. Which conclusion about its long-run average cost is correct?

Output rising by only 80% when all inputs double means decreasing returns to scale. Total cost doubles while output grows less, so long-run average cost rises as the firm expands, showing diseconomies of scale rather than constant or increasing returns.

  1. AIt faces constant returns to scale and flat long-run average cost
  2. BIt faces increasing returns to scale and falling long-run average cost
  3. CIt faces decreasing returns to scale, so long-run average cost rises with scaleCorrect
  4. DIt faces diminishing marginal returns, which is a long-run concept only
  5. It has fixed costs that cause average cost to rise

Explanation

Doubling inputs should double cost at constant input prices, but output rises by less than double, so cost per unit rises. This is decreasing returns to scale, or diseconomies of scale. Diminishing marginal returns concern one variable input with another fixed, a short-run idea.

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