In economics, diminishing returns (also called diminishing marginal returns) is the decrease in the marginal output of a production process as the amount of a single factor of production is increased, while the amounts of all other factors of production stay constant. The law of diminishing returns states that in all productive processes, adding more of one factor of production, while holding all others constant ("ceteris paribus"), will at some point yield lower per-unit returns . The law of diminishing returns does not imply that adding more of a factor will decrease the total production, a condition known as negative returns, though in fact this is common.
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Diminishing Returns
As a factor of production (F) increases, the resulting gain in the volume of output (V) gets smaller and smaller.
For example, the use of fertilizer improves crop production on farms and in gardens; but at some point, adding more and more fertilizer improves the yield less per unit of fertilizer, and excessive quantities can even reduce the yield. A common sort of example is adding more workers to a job, such as assembling a car on a factory floor. At some point, adding more workers causes problems such as workers getting in each other's way or frequently finding themselves waiting for access to a part. In all of these processes, producing one more unit of output will eventually cost increasingly more, due to inputs being used less and less effectively.
This increase in the marginal cost of output as production increases can be graphed as the marginal cost curve, with quantity of output on the x axis and marginal cost on the y axis. For many firms, the marginal cost curve will initially be downward sloping, representing added efficiency as production increases. If the law of diminishing returns holds, however, the marginal cost curve will eventually slope upward and continue to rise, representing the higher and higher marginal costs associated with additional output.
The Law of Diminishing Returns and Average Cost
The average total cost of production is the total cost of producing all output divided by the number of units produced. For example, if the car factory can produce 20 cars at a total cost of $200,000, the average cost of production is $10,000. Average total cost is interpreted as the the cost of a typical unit of production. So in our example each of the 20 cars produced had a typical cost per unit of $10,000. Average total cost can also be graphed with quantity of output on the x axis and average cost on the y-axis.
What will this average total cost curve look like? In the short run, a firm has a set amount of capital and can only increase or decrease production by hiring more or less labor. The fixed costs of capital are high, but the variable costs of labor are low, so costs increase more slowly than output as production increases. As long as the marginal cost of production is lower than the average total cost of production, the average cost is decreasing. However, as marginal costs increase due to the law of diminishing returns, the marginal cost of production will eventually be higher than the average total cost and the average cost will begin to increase. The short run average total cost curve (SRAC) will therefore be U-shaped for most firms .
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Cost Curves in the Short Run
Both marginal cost and average cost are U-shaped due to first increasing, and then diminishing, returns. Average cost begins to increase where it intersects the marginal cost curve.
The long-run average cost curve (LRAC) depicts the cost per unit of output in the long run—that is, when all productive inputs' usage levels can be varied. The typical LRAC curve is also U-shaped but for different reasons: it reflects increasing returns to scale where negatively-sloped, constant returns to scale where horizontal, and decreasing returns (due to increases in factor prices) where positively sloped.