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
In the short run, marginal returns (MR) increase with the addition of three workers, after which diminishing returns occur with the addition of each individual worker
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
- There is an inverse relationship
Diagram: Connecting the Shapes of the Short Run Cost Curves
The marginal cost curve is the supply curve of a firm. Marginal costs fall as long as there are increasing marginal returns
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