1.4.3 The Law of Diminishing Returns and Returns to Scale

The Difference Between the Short Run and Long Run

Short Run: The period of time in which at least one factor of production is fixed. For example, a firm may be able to vary the amount of labour it uses in production, but the size of its factory is fixed.

In the short run, firms are subject to the law of diminishing returns.

Long Run: The period of time in which all factors of production can be varied. For example, a firm may be able to vary the amount of labour it uses in production, and it may also be able to build a larger factory or purchase more machinery.

In the long run, firms are subject to returns to scale.

Marginal, Average, and Total Returns

Marginal Returns: The additional output produced by employing one more unit of a variable factor, typically labour.

Average Returns: The mean output produced per unit of a variable factor, typically labour.

Total Returns: The total output produced by a firm.

The Law of Diminishing Returns

In the short run, at least one factor of production is fixed. For example, a firm may have a fixed amount of capital (machinery) but can vary the amount of labour it employs.

Adding more variable factors, such as labour, will initially increase productivity, but eventually diminishing marginal returns set in.

Diminishing Marginal Returns: The phenomenon where adding more of a variable input (like labour) to a fixed input (like machinery) results in smaller increases in output after each input is added. This is because the fixed input becomes a constraint, leading to inefficiencies.

For example, if a pub has a fixed number of bar counters, adding more bartenders will eventually lead to overcrowding and reduced efficiency, as they get in each other's way.

This concept is responsible for the shape of the Marginal Cost curve. Initially, as more labour is added, productivity increases, causing MC to fall. However, eventually diminishing marginal returns set in, and adding more units of labour leads to higher costs of increasing output.

Returns to Scale

In the long run, all factors are variable, so the firm can change its scale of production.

Returns to Scale: a concept that describes how output changes if all inputs are increased proportionally. This can only occur in the long run, when all factors of production are variable.

Increasing Returns to Scale: When output increases by a greater proportion than the increase in inputs. For example, if a firm doubles its inputs and output more than doubles, it is experiencing increasing returns to scale.

Constant Returns to Scale: When output increases by the same proportion as the increase in inputs. For example, if a firm doubles its inputs and output also doubles, it is experiencing constant returns to scale.

Decreasing Returns to Scale: When output increases by a smaller proportion than the increase in inputs. For example, if a firm doubles its inputs and output less than doubles, it is experiencing decreasing returns to scale.