## The Law of Diminishing Returns in a Toy Truck Factory

The law of diminishing returns is a simple, yet fundamental concept in economics. When the producer of a good wishes to expand its output, in the short-run it may do so by employing more workers or having its existing workers work longer hours. To acquire more capital and technology or to build new factories takes time and money, thus we say that in the short-run, a firm’s plant size is fixed; the only variable resource is labor.

But to what extent can production increase when only the amount of labor employed can change? This video lesson explains the principle of diminishing marginal returns, which says that as additional units of a variable resource (labor) are added to a fixed resource (capital), beyond a certain point the output attributable to additional units of the variable resource will decline. With only a limited supply of technology at their disposal, workers in a factory can only increase their productivity to an extent.

If a firm wishes to expand its production in the long-run, it must acquire more capital in order to allows for continued increases in the productivity of labor. This video will illustrate, using a toy truck factory employing tools and labor, the principle of diminishing marginal returns.

For some lesson ideas and blog posts on Diminishing Returns, check out this page from my blog: Economics in Plain English – the Law of Diminishing Marginal Returns

## Understanding the relationships between Total, Marginal and Average Product

This lesson is the second in the series on short-run costs of production and the law of diminishing returns. Before watching this video, make sure you’ve seen the last one in the series: THE LAW OF DIMINISHING RETURNS IN A TOY TRUCK FACTORY

In this lesson we will examine the changes in productivity experienced as more labor is added to a fixed amount of capital, measuring not only the total product, but also the marginal and average outputs of labor. Once we have output data in a table, we will graph the TP, MP and AP curve and examine the mathematical relationships between these curves.

Understanding the relationships between a firm’s short-run productivity curves will provide us with a basis for understanding how a firm’s costs of production change as the firm varies its level of output in the short-run.

## Short-run Productivity, Costs and the Law of Diminishing Marginal Returns

In the last lesson it was shown how the law of diminishing marginal returns affects the productivity of labor as a firm varies the number of workers employed towards the production of its output in the short-run. Due to the fact that capital and land are fixed in quantity, the addition of more workers to a factory will ultimately lead to the marginal product of labor declining, and even becoming negative if too many workers try to squeeze into a limited amount of space and work with a fixed number of tools.

The most significant implication of the law of diminishing marginal returns for a producer is the effect it has on a firm’s costs of production in the short-run. A firm’s variable costs are determined by the productivity of labor, since labor is the primary variable resource. When worker productivity is rising, a firm’s costs are falling; but when the firm begins experiencing diminishing marginal returns, productivity fall and the cost of additional units of output begins to rise.

This lesson illustrates using data and graphs the relationship between productivity and costs in the short-run, and how the law of diminishing marginal returns determines the shapes of the short-run cost curves: marginal cost and average variable cost.

## The Relationships between Short-run Costs of Production

This lesson will examine the relationships between a firm’s short-run, per-unit costs of production: the marginal costs, average variable and average total costs of production (as well as, although not explicitly, the average fixed cost).

Previous lessons have explored the law of diminishing marginal returns, its effect on the productivity of a variable resource in the short-run (assumed to be labor) and how productivity and costs are related:

This lesson focuses on just the per-unit cost curves, their shapes, and the relationships between them. As you will see, the marginal cost curve, itself shaped by the law of diminishing returns, intersects the average cost curves at their lowest points, which as we will see in later lessons enables producers to choose a level of output at which their per unit production costs are minimized, enabling firms to make decisions that allow them to optimize their output for profit-maximization.

## Long-run Average Total Cost and Economies of Scale

When a firm has time to expand or reduce the amount of capital and land it employs in its production, it may find its average, per-unit production costs either rising or falling with the amount of capital it uses. This phenomenon is known as economies of scale (or size).

Sometimes, the larger a firm becomes, the more it produces, the lower its average costs of production. On the other hand, it is possible for a firm to become too big for its own good, and experience diseconomies of scale: when producing more output leads to rising average costs.

This lesson distinguishes between a firm’s short-run average total cost and its long-run average total cost, and explains how economies of scale may help a firm achieve lower average costs as it increases its output in the long-run.

## Short-run Costs of Production QUIZ – Worked Solution

This lesson provides a worked solution to a quiz on a firm’s short-run costs of production. The quiz should be downloaded and attempted first.

Short-run Costs of Production Quiz