explaining-the-shapes-of-the-cost-curves

Diminishing Returns Shape the Short-run Cost Curves

• In the short-run, the shapes of the cost curves (AC, AVC & MC) are determined by the law of diminishing marginal returns. This fully explained on the page Diminishing Returns & Returns to Scale

Diagram: The law of Diminishing Marginal Returns

Diagram analysis

• A small food van selling burgers (product) at a music festival increases productivity up to the addition of a third worker

  • After that, workers get in each other’s way and there is not enough grill space (capital) and the marginal return no longer increases

  • If more workers are hired, then the marginal return of each additional worker begins to fall

• Adding additional workers up to the 7th worker will keep increasing the total output

  • With the hiring of the 7th worker, the marginal return turns negative, which will decrease the total output

Using diminishing marginal returns to explain the short-run cost curves

• As the marginal returns increase, the marginal costs decrease

  • There is an inverse relationship

    • Increasing returns = decreasing costs

    • Decreasing returns = increasing costs

Diagram: Connecting the Shapes of the Short Run Cost Curves

Diagram analysis

• The distance between the average variable cost (AVC) and the average cost (AC) = the average fixed cost (AFC)

  • AVC converges towards AC as the AFC continuously decreases with an increase in output

  • AVC decreases as additional workers are added and each worker produces additional product

• Marginal costs (MC) decrease initially as additional workers are added & the marginal product is increasing

• Diminishing returns begin when the MC starts to increase

• MC will cross the AVC and AC curves at their lowest point

  • As long as the cost of producing the next unit (MC) is lower than the average, it will pull down the average

  • When the cost of producing the next unit (MC) is higher than the average, it will pull up the average

The Impact of Costs & Productivity on Factor Inputs

• Factor prices (raw materials, wages, etc) and productivity shape a firm’s costs of production and influence its choice of factor inputs

  • Factor inputs used in the production process can either be capital-intensive or labour-intensive

The influence of factor prices on costs

• Higher factor prices increase production costs, e.g. if wages rise due to labour market conditions or changes to the national minimum wage, a firm’s labour costs will increase

• Lower factor prices reduce production costs e.g. if the cost of capital decreases, possibly due to interest rate reductions that make repayments more affordable, a firm’s costs of production decrease

• Firms aim to minimise costs by selecting the optimal combination of inputs that maximises output

The influence of productivity on costs

• Productivity measures the efficiency with which inputs are utilised to produce output

• Higher productivity means more output can be produced with the same level of inputs

  • Improved productivity lowers a firm’s production costs by reducing the number of inputs required to produce a given level of output

  • E.g. If technological advancements allow workers to produce more units per hour, the firm’s labour costs per unit decrease

• Lower productivity increases costs because more inputs are needed to produce the same level of output

  • If workers become less efficient or if capital equipment becomes outdated, a firm’s costs of production rise

The Influence of factor price and productivity on input

• Firms choose between capital and labour inputs based on factor prices and productivity levels

  • If capital (machinery) costs are low relative to labour costs and capital is highly productive, firms may opt to use more capital-intensive production methods

  • If labour costs are low and labour is highly productive, firms may prefer labor-intensive methods