Board of Governors of the Federal Reserve System
International Finance Discussion Papers
Number 546
March 1995
RETURNS TO SCALE IN U.S. PRODUCTION: ESTIMATES AND IMPLICATIONS
Susanto Basu and John G. Femald
N InF D P p m c s
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comment. References in publications to International Finance Discussion Papers
(other than an acknowledgment that the writer has had access to unpublished material) should be cleared
with the author or authors.
ABSTWCT
A typical (roughly) two-digit industry in the United States appears to have constant or slightly decreasing
returns to scale.
Three puzzles emerge,
h F e at higher levels of
aggregation. Second, estimates of decreasing returns in many industries contradict evidence of only small
economic profits. Third, estimates using value added differ substantially from those using gross output,
a l r
These puzzles inconsistent with a representative firm paradigm, but are
consistent with simple stories of aggregation over heterogeneous units. We discuss implications of this
heterogeneity for recent models of impetiect competition in macroeconomics.
RETURNS TO SCALE IN U.S. PRODUCTION: ESTIMATES Am IMPLICATIONS
Susanto Basu and John G. Femald]
Why is productivity procyclical? That is, why do measures of labor productivity and total factor
productivity rise in booms? The answer to this question sheds light on the relative merits of different
models of business cycles. One recent class of explanations emphasizes the potential role of imperfect
competition and increasing returns to scale.
Measured total factor productivity then reflects not just
technology shocks, but also variations in input use. Robert Hall (1988, 1990), especially, has argued that
relaxing the traditional assumptions of perfect competition and constant returns helps explain procyclical
productivity.
In addition, recent papers show that increasing returns and imperfect competition can modi~ and
magnify the effects of various shocks in an otherwise standard dynamic general equilibrium model. In
response to government demand shocks, for example, models with countercyclical markups can explain
a r real wages while models with increasing returns can explain a rise in measured productivity.
Perhaps most strikingly, if increasing returns are large enough, they can lead to multiple equilibria, in
which sunspots or purely nominal shocks drive business cycles.z
‘ The authors are respectively: Assistant Professor of Economics at the University of Michigan and
Faculty Research Fellow of the National Bureau of Economic Research; and Staff Economist in the
Division of international Finance, Board Governors of the Federal Reserve System, Please address
correspondence to S. Basu. Department of Economics, University of Michigan, 611 Tappan St., Ann
Arbor, MI 48109-1220; or J. Femald, Mail Stop 20, Federal Reserve Board, Washington, DC 20551..
This is a substantially revised version of a paper previously circulated as “Constant Returns and
Small Markups in U.S. Manufacturing.”
We thank Russ Cooper, Dale Jorgenson, Sam Kortum, Greg
Mankiw, Stephanie Schmitt-Grohe, and an anonymous referee for helpful comments, and Barbara
Fraumeni for help with the data. We particularly thank Mike Woodford for extensive written comments
on an earlier version of this paper.
Basu is grateful to the National Science Foundation for financial
support and to the Hoover Institution for its hospitality. This paper represents the views of the authors
and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve
System or other members of its staff.
2 See, for example, Rotemberg and Woodford (1992), Farmer and Guo (1994), and Beaudry and
Devereux (1994). For a survey of dynamic general equilibrium models with imperfect competition, see
Rotemberg and Woodford (1995).
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