Diminishing Returns vs. Economies of Scale

Diminishing Returns vs. Economies of Scale

DMR (Short-Run effect) - adding more inputs(labor) to a fixed factor of production(factory) will lead to increasing output but eventually as more inputs are added output will decrease and eventually become negative.

We understand this as we have graphed it quite a bit.

As we add our initial amounts of labor the marginal product (the output attributed to the next worker hired) increases as workers are more efficient (able to specialize) at their work. Adding more and more workers will increase the the TP (total product) output but at a decreasing rate. If we are foolish and keep adding workers the amount of output will eventually start to decrease and eventually become negative.

Understand that the MC curve is the cost of Labor and the MC curve above the AVC curve is the firms supply curve.

D = P = MR = AR

Short-run Adjustments (firm)

If MR > MC we should hire more workers (increase output)

if MR < MC then we should fire some workers (decrease output)

If MR = MC then we are at profit max,, optimal quantity of workers.

In the Short-Run the firm can only adjust its amount of labor (output). 

We adjust our amount of output (quantity) to maximise profit (MR=MC). This of course changes as the price of the good increases or decreases. As the (price of the good) increases we can make more profit and therefore hire more labor.

We adjust our labor to the profit maximising point where MRP=MRC, this is from the resource costs section of the course. (Usually taught at the end of the course)

Understand that the Max profit point is where MR=MC and where MRP=MRC,,,, if there was a quantity of labor that would create more profit then we wouldn't be at profit max. 

So if we are at MR =MC, then we must be where MRP=MRC.

If MRP > MRC we should hire more workers (increase output)

if MRP < MRC then we should fire some workers (decrease output)

If MRP = MRC then we are at profit max,, optimal quantity of workers.

Conclusion - In the short-run the firm must choose the optimal amount of labor to reach profit max (The firm and society in general is constrained by diminishing marginal returns) 

EOS - (Long-Run Effect) - Competitive advantages gained by a firm that expands its size. These include efficiencies such as buying in bulk and therefore reducing unit costs or having one human resource department shared between factories.

Adjustments - enter/exit of firms, increase or decrease of firm size

In essence, EOS depends on the size of firms that can fit into an industry. If demand for the good increases and as firms rush into the industry and our firm grows larger and resource costs still fall then we say the firm has economies of scale (EOS). The industry can handle more firms and existing firms should increase their size. The firms LRATC's are falling as they produce more output(quantity).

If the firm becomes to large and loses efficiency due to being to large, then diseconomies of scale will occur. 

If the industry has the right amount of efficiency and size then we will say that the industry is a constant cost industry and resource prices are not affected by firms entering or exiting the industry.

Check out the LRS/LRATC curve cheat Sheet here.

(not quite finished)

Conclusion - depending on the industry's economies of scale - (constant, decreasing, increasing) 

If a company can achieve EOS then the company should expand (produce more)

If the firm's to big increasing costs then they should reduce their size (produce less)

If a firm is of an efficient size (in a constant cost industry) the they are at productively and allocatively efficient. The firm is producing at the minimum of the SRATC and the LRATC curve.

Perfect Competition (Long Run Supply/ATC Curves)

Perfect Competition (Long Run Supply/ATC Curves)

This stuff seems to give students crazy hard time. (because its complicated)

(see a problem drop me a line (wcwaugh@aol.com))

Creating this to mimic the AP College Boards FRQ's

1) Perfectly Competitive firm in long run equilibrium in a constant cost industry.

a) Demand increases (Price and quantity increases)

b) Firm makes profits (show) in SR

c) In the LR firms enter pushing supply back to original price.

d) Long Run supply curve is horizontal (firms enter but price of good doesn't change)

e) In a constant cost industry the firm is allocative and productively efficient

So, most FRQ's start with the firm in Long-Run Equilibrium and then market demand increasing/decreasing. The College Board asks you to show the effect of the market demand, profits/losses. 

Easy up to this point, Yes?

Then they ask you to explain what happens to the long run supply curve and what happens to the price in the market (compared to the original price).

Know that the Long Run Supply curve is simply a line drawn between the original equilibrium point and the equilibrium point after all firms have entered/exited the market. It shows the quantity supplied once producers have had time (long run) to enter/exit the industry.

Sometimes its easier to see the big picture or the flow of things. 

In essence the market is in equilibrium, no firms want to enter or exit as the existing firms are all making a normal profit. 

This implies that no adjustments need to be made.

No adjustments in the short-run (no labor needs to be hired or fired) and,

No adjustments in the long run (no firms entering or exiting the industry) 

then something happens (Demand increases) Why??? Look back at the Demand Supply Cheat Sheet!

Lets just say population increases,, so demand increases. (profits happen for firms)

These firms adjust in the short-run by hiring more labor.

Due to diminishing marginal returns firms might need to buy a larger factory and/or more machinery.

In the long-run (remember?) firms can enter/exit but also more capital can be added (factories and machinery) for firms that need to expand.

Supply increases but in this instance, supply increases proportionately more than demand had increased.

This is due to resource prices used in production decreasing marginally due to economies of scale.

More supply pushes the price of the good lower than the original price,, this happens again and again 

How does this look over time.

 Notice that demand increases but less than the supply curve increases. Prices are falling as firms get larger due to economies of scale. Think agriculture. At the turn of the last century in the US, 80% of the people worked on farms now the percentage is around 2%. Firms got more productive and much larger.

Food costs have fallen due to technology and the industry adjusted with different levels of labor/capital mixes.

What if we draw in the ATC curves in the short run. Here is the same graph above with the short-run atc curves drawn.

Understand that at each ATC curve is a point in time where the firm is back to equilibrium (normal profit) and has no reason to enter or exit. Then demand changes and firms scramble to supply more goods/services. As they hire more labor with the existing machinery/factories their costs rise and they decide to increase factory size. This increasing of factory/machinery lowers ((((marginal costs)))

Mr. Waugh, where is the Long-Run Supply Curve

Draw a line through all of the Long-Run Equilibrium points and you have your  Long-Run Supply Curve

Understand that in this decreasing cost industry, as demand increase, supply responds in ways that price falls in the market due to ATCs falling for the firm. 

There are connections to this graph.

In the above Firm graph,, if we are producing where MR>MC then we should produce more. How? Hire more people...   If we are producing where MC>MR then we should produce less. How?? Fire some people. We want to produce where MR=MC = Profit Max. This is the quantity society wants MC=MB from societies standpoint.

Now lets look at the Long-Run ATC curve with LRMR and LRMC

Left Side, a short run ATC and MC curve on a LRATC curve,, the Firm in the short run needs to increase in size, or more firms need to enter as costs can be driven down because of EOS.. More will be produced and society will pay for it. (((Assuming that the Demand increases)))

Right Side, this industry has to many firms or its firms are to large and costs are rising. Firms are to large or there are to many firms.

Middle - Constant cost industry, firms enter and exit without price changes. This is approximately the right amount of firms in this industry at this point.