Explain the law of diminishing returns using average and marginal product curves

Demands of the question

  1. 10 marks (paper 2)
  2. 20 minutes on it
  3. Explain the law of diminishing returns using average and marginal product curves

Definition

  1. Law of diminishing returns refer to how the marginal production of a factor of production starts to progressively decrease as the factor is increased, in contrast to the increase that would otherwise be normally expected.

Triple A

Law of diminishing returns – as more and more of a variable factor is added to a fixed factor, output will rise initially but will eventually fall.

Initially, in region 0 – A, there are increasing returns. In the zone A – B there are decreasing returns, and beyond B there are negative returns.

This theory supports the shape of the marginal and average cost curves. Both of these curves will be u-shaped as eventually diminishing returns will lead to costs increasing. Initially increasing returns mean that both AC and MC will fall, but once diminishing returns set in both curves start to rise again.

The marginal cost curve will intersect the average cost curve at its minimum point.

The actual position of the AC curve will vary with a number of factors.

  • Costs of factor inputs (labour, materials, services etc). The cheaper the inputs the lower the average cost will be at any given output.
  • Productivity – productivity can be defined as output per unit input. The more productive the firm, the more output it gets from its inputs and the lower the average cost at any output.

Productivity is measured in a number of ways:

  • Marginal product (MP) – the change in total output resulting from the adding of one extra unit of a variable factor, often labour.
  • Average product (AP) - total output / units of variable factor being used.

The choice of factor inputs will be driven by their costs, productivity and effect on product cost. An efficient firm will make its choices so as to minimise its average cost at the production rate being worked. Look at the following example.

Sum up the main idea

The essence of this explanation is that the supply price that sellers are willing and able to receive for a good depends on the production cost. If the production cost increases, then the sellers need a higher supply price. Because the marginal product of a variable input declines with greater production, more of the variable input is needed, which increases production cost.

The law of diminishing marginal returns is reflected in the shapes and slopes of the total product, marginal product, and average product curves. The most important of these being the negative slope of the marginal product curve.

Powerpoint slides


Diagrams

The average product typically varies as more of the input is employed, so this relationship can also be expressed as a chart or as a graph. A typical average physical product curve is shown (APP). It can be obtained by drawing a vector from the origin to various points on the total product curve and plotting the slopes of these vectors.

Because the marginal product drives changes in the average product, we know that when the average physical product is falling, the marginal physical product must be less than the average. Likewise, when the average physical product is rising, it must be due to a marginal physical product greater than the average. For this reason, the marginal physical product curve must intersect the maximum point on the average physical product curve.

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