Question

What are diminishing marginal returns as they relate to costs?

Short answer

Diminishing marginal returns is an economic concept that describes a situation where the incremental output per unit of input decreases as additional units of input are used in the production process. This leads to higher costs of production, since the productivity per unit of input declines, resulting in a higher cost per unit of output. This phenomenon is caused by factors such as limited resources, the presence of fixed inputs in the short run, and diminishing efficiency in employing additional inputs. As a result, the costs of production start to rise, affecting decisions related to resource allocation and cost management.

Step-by-step solution

Definition of Diminishing Marginal Returns

Diminishing marginal returns, also known as the law of diminishing returns, is an economic concept that describes a situation in which the incremental output per unit of input decreases as additional units of input are used in the production process. In other words, the returns from employing an extra factor of production, such as labor or capital, start to decline after a certain point.

Relation to Costs

When diminishing marginal returns start to occur, the costs of production begin to increase. This is because, as additional units of input are used, the productivity per unit of input decreases, leading to a higher cost per unit of output. This can be clearly seen when observing the marginal cost curve, which represents the additional cost of producing one more unit of output.

Understanding Marginal Returns

Marginal returns, also known as the marginal product of a factor of production, represents the change in total output resulting from using an additional unit of input while keeping other factors constant. As long as marginal returns are positive and increasing, costs will be lower as more units are produced. However, when marginal returns start to decline, costs will start to rise as more and more resources are required to produce a smaller increase in output.

The Concept of Diminishing Returns

Diminishing returns occur because of factors like limited resources, the presence of fixed inputs in the short run, and diminishing efficiency in employing additional inputs. When an additional unit of input is used in a production process, it leads to a lower contribution to the total output, thereby increasing the cost of producing each unit of output.

Example

Assume a factory that produces widgets. Initially, as more workers are added to the production process, each worker is able to specialize and productivity increases. Output per worker will rise, and the cost per widget will decrease. However, at some point, hiring more workers will not result in the same increase in productivity. This could be due to limited space in the factory, inefficient coordination of tasks, or other factors that would lead to a decline in the marginal product of labor. As a result, marginal returns start to decrease and costs begin to rise. In conclusion, diminishing marginal returns is an important concept in understanding the relationship between costs and productivity. As the marginal product of input starts to decline, the costs of production start to rise, which influences various business decisions related to efficient allocation of resources and cost management.