Nov 15 2010

Diminishing returns and the short-run costs of production – “Econ Concepts in 60 Seconds”

YouTube – Econ Concepts in 60 Seconds: The Law of Diminishing Marginal Returns

Mr. Clifford, an AP Economics teacher from San Diego, demonstrates the law of diminishing returns by deriving a total product and marginal product curve using production data from a student’s lawn mowing business.

Econ Concepts in 60 Seconds: The Law of Diminishing Marginal Returns The video above is most useful to Econ students because it enforces the Law of Diminishing Returns. The more important application of this basic economic concept, however, is the short-run per-unit cost curve, Marginal Cost, Average Variable Cost and Average Total Cost. Mr. Clifford offers his quick explanation of the relationships between a firm’s short-run costs in the following video.

Econ Concepts in 60 Seconds: Per Unit Costs Curves

Discussion Questions:

  1. Mr. Clifford derives a Marginal Product Curve in the first video and a Marginal Cost Curve in the second video. What is the relationship between the marginal product of a firm’s variable resource and the firm’s marginal cost of production? How are the shapes of both these curves determined by the law of diminishing marginal returns?
  2. Why does a firm care about its costs of production? Which of the four per-unit cost curves in the second video would a firm be most concerned with when determining whether or not it is earning profits or losses?
  3. What can cause a firm’s cost curves to shift up or down? How would a shift of the cost curves affect a firm’s profits?
  4. What is the primary economic goal of firms, and how can understanding their short-run costs of production help them achieve this goal?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

21 responses so far

21 Responses to “Diminishing returns and the short-run costs of production – “Econ Concepts in 60 Seconds””

  1. Gavin Steinhublon 25 Nov 2009 at 4:16 am

    4. The primary economic goal for firms are to maximize profit. It's obvious that the reason entrepreneurs begin a business is to maximize profit. If no profit was made or the firm took a loss, then the firm would be pointless and the opportunity cost would outweigh the benefits. Because this is the main goal for firms, they need to be aware of their short run costs. Short run costs are all costs that occur within the short run, which is defined as a period too brief to alter plant capacity. Because profit is gained only when the revenue is greater than the costs, to maximize profit the firm would strive to lower its costs, including short-run costs. This could be the wages for a employee. If the costs are too high you could alter the short run cost of salaries

  2. Amiton 25 Nov 2009 at 7:47 am

    3. A firms costs can be affected by a change in the markets of one of its factors of production: rent, wages, interest. For example an influx in immigrants or new resources found can affect rent and wages. Similarly, new technology or machinery can affect the efficiency of the tools and as a result the interest paid. Costs concern firms because as Gavin so eloquently stated, firms are profit seekers. Their goal is to maximize profits by creating the biggest difference between revenue and costs. Obviously there is a correlation between costs and profit. Ceteris Paribus, revenues remain the same, there is an inverse relationship between costs and profits. So if costs went up then profits would go down and if costs decreased profits would increase. As a result firm's must pay attention to all the factors that could cause a shift in its costs.

  3. Jasonon 25 Nov 2009 at 3:56 pm

    2.

    A firm cares about its costs of production, because that is what determines whether the company is making profits, or losses. No matter how high the firm's revenue is, if the costs are higher, the company is losing money. The Average Total Cost curve (ATC) is most likely the most useful for discovering if the firm is making profits or losses. If the ATC (which consists of the AFC and AVC) is higher (say $5) than the price-per-unit (say $4), than for each unit, then the firm is spending $5 to make something they are selling for $4, and they are losing $1 per unit they sell. However, even though they are losing money, it may still be worth producing in the short run, because if the Fixed cost (that the firm has to pay anyway no matter what production rate) is higher than the loss-per-unit x quantity produced, the way to minimize losses would be to produce instead of closing down.

  4. Lara Bullenson 25 Nov 2009 at 6:45 pm

    1. Mr. Clifford derives a Marginal Product Curve in the first video and a Marginal Cost Curve in the second video. What is the relationship between the marginal product of a firm’s variable resource and the firm’s marginal cost of production? How are the shapes of both these curves determined by the law of diminishing marginal returns?

    First we need to understand that, marginal product is the extra output that is produced and that marginal cost is the increase in total cost of producing an extra unit of output. The difference between the marginal product of a firm's variable resource and the firm's marginal cost of production is that, whilst the quantity of the variable factor increases the marginal product first increases to a certain point and then decreases. But as the output in units of a firm increases, the marginal cost decreases and at a certain point begins to increase again. The law of diminishing margianl returns states that as extra units of a variable factor are added to a given quantity or a fixed factor, the output from each additional unit of the variable factor will eventually diminish. We can determine these shapes of these curves by this law because as we can see in the marginal product, as more of the variable product is added to the fix product, the curve eventually falls. And, marginal cost falls as the output increases, and then starts to rise again as the output continues to increase.

  5. John Remmerton 25 Nov 2009 at 8:08 pm

    4) What is the primary economic goal of firms, and how can understanding their short-run costs of production help them achieve this goal?

    The primary economic goal of firms is to maximize profit. Profits are maximized by understanding the firms short-run costs. A short-run cost is a cost the firm has, that is made in a short period of time when there is not enough time to change the amount of factories for example. Short-run costs include such things as wages. Profits are made when the income out-weighs the costs. If the wages were too high for the firm to make a profit then wages would have to be lowered or jobs cut.

  6. Jennie (and Gabe)on 25 Nov 2009 at 8:09 pm

    What can cause a firm’s cost curves to shift up or down? How would a shift of the cost curves affect a firm’s profits?

    A firms costs curves can shift due to taxes, minimum wage increase or increase in costs of materials. When there is a shift in cost, ceteris parabis, a firms profits decreases. If the costs are higher than the profits the firm makes a loss.

  7. Liviaon 25 Nov 2009 at 8:11 pm

    2. A firms costs of production are important because they determine whether a firm will have profits or losses. If the firm is paying more money(costs off LLCE) then they are receiving(revenue) they will have losses. ATC and AVC are the two most important curves to determine profits. If the point of production is above ATC a firm will earn profits, if it is between ATC and AVC the firm will be at breakeven and if it is below AVC the firm should shutdown because of its losses.

  8. Lara Fuhrmannon 25 Nov 2009 at 8:11 pm

    2.Why does a firm care about its costs of production? Which of the four per-unit cost curves in the second video would a firm be most concerned with when determining whether or not it is earning profits or losses?

    A firm cares about its costs of production, because its goal is to get the most profits for the least money. The firms costs determine if they are making losses or profits. A firm wants to make the most profits possible. If the firm makes losses, they quit and shut down. But if they are making profits the gain a lot of money, so they get rich. A firm doesn't want to lose money it wats to get money. So for every extra labor if the average cost and the total cost go up the labor was worth the money, else they fire the worker, because the have lost money and didn't gain.

  9. Mhairi Hutchisonon 25 Nov 2009 at 8:13 pm

    4. The primary economic goal of firms is to make a profit. The short-run costs of production are the costs of production during a very small amount of time and it is important for a firm to be aware of their short-run costs. To gain a profit, their product must be cheaper to make than the amount that they are selling it for. Therefore, if they are making losses, they have to lower their costs. This includes the short-run production for example they must use less workers or increase their amount of capital.

  10. Gelando Makrideson 25 Nov 2009 at 8:13 pm

    3. What can cause a firm’s cost curves to shift up or down? How would a shift of the cost curves affect a firm’s profits?

    The three most important costs of production are rent for land resources, wages for labor resources and interest for capital resources. A change in the cost of any of these can reflect a shift in all of the firm's cost curves. For example, if wages for factory labor suddenly rose and labor is a variable cost, this would reflect a upward shift in the ATC curve, AVC curve, and MC. curve. If income was to stay constant and there was a shift in the cost of production, the total profits would change as well. An upward shift in cost curves would result in a lowering of the firm's profits.

  11. Felipe R-Lopezon 25 Nov 2009 at 8:14 pm

    4.What is the primary economic goal of firms, and how can understanding their short-run costs of production help them achieve this goal?

    The primary economic goal of firms is to maximize economic profits. Understanding their short-run costs of production is vital to helping them achieve this. A short-run graph shows the per-unit cost of each unit produced, as well as the average variable cost of each unit and the average fixed unit of each unit. In addition to this, a marginal cost graph is drawn. In order to maximize profits, a firm needs to have the price of each unit above the ATC costs, but understanding the other curves are important as well. If one sees, for example, Marginal cost rising very quickly, a firm has time to respond to this, in case TC rises proportionally and passes price of the unit.

  12. Christa_bon 25 Nov 2009 at 8:15 pm

    The firm’s primary goal is to maximize profit, and to maximize profit a firm must lower their costs. To be able to lower costs a firm must understand their short- run costs. The short-run is defined as the period of time where a firm is not able to alter factory size. The firm’s revenue must outweigh the firms costs, so by understanding the short-run costs, the firm will be able to cut it’s cost so it is able to maximize it’s profit.

  13. Ray Remmerton 25 Nov 2009 at 8:16 pm

    Why does a firm care about its costs of production? Which of the four per-unit cost curves in the second video would a firm be most concerned with when determining whether or not it is earning profits or losses?

    A firm cares about it cost of product because it determines whether or not the company is making a profit or loss. The firms total costs must remain below total revenue in order to make a profit. The cost curve that a firm would be most concerned when determining whether they are making a profit or not would be the Average Total Cost curve. The ATC curve must remain below the revenue in order for the company to make a profit. It the ATC of a single unit produced is $10, but the product only sells for $9, the company is losing money.

  14. Saraon 25 Nov 2009 at 8:22 pm

    The primary economic goal of firms is to maximize their profits and minimize their costs. Their aim is to make sure profits outweighs opportunity cost. To make profit, a firm's total revenue must be bigger than it's total costs.

    By understanding the short-run production costs, firms can calculate and develop a better understanding of how to maximize their profits and minimize their costs in the short-run period.

    The short-run period is also referred to as the fixed plant period. This means that assets such as rent and interest are fixed while resources such as labour can still vary. By lowering the wages of their workers, the firm can cut back on their costs in the short-run period. The firm can also cut back on additional units of labour that did not add as much as the previous unit of labour. These additional units do the exact opposite of what firm's are aiming to achieve by decreasing total revenue and increasing total cost so those units should be eliminated in the short-run period.

  15. Drew B Von 25 Nov 2009 at 8:41 pm

    1. There is an inverse relationship between the marginal product of a firm’s variable resource and the firm’s marginal cost of production. As the law of diminishing marginal returns states that as additional units of a variable resource are added to fixed resources, beyond some point the marginal product of the variable resource will decline. This is represented on the marginal product line because at first MP is increasing at a decreasing rate, and once it reaches its peak, it starts to decrease. Since marginal cost is the inverse of marginal product, marginal cost decreases first, then at the same point that MP reaches its peak, MC reaches its low, and then starts to increase.

  16. […] WW Blog – Diminishing Returns and graphing short-run costs (Read and respond to the discussion questions as a table group) […]

  17. Silvia Dieteron 26 Nov 2009 at 7:08 pm

    4. The primary economic goal for firms is to maximize their profit. In order to do so, the firms need to be aware of their short-run costs. Firms have to cover these costs while producing their good or service in a short amount of time. To maximize the price of their product, the firms total revenue has to be higher than the cost they have to cover. Therefore a short-run costs table helps firms to cut costs and maximize their profit.

  18. Thomason 30 Nov 2009 at 2:21 am

    2. Why does a firm care about its costs of production? Which of the four per-unit cost curves in the second video would a firm be most concerned with when determining whether or not it is earning profits or losses?

    – A firm cares about its cost because they want to maximize their profit and make sure that they will not be making a loss, increased costs will cut into their profit so they want the minimum cost for every unit that they produce. The curve that a firm would be most interested in is ATC, because they would need to lower this cost to get the greatest average profit for each unit that they produce. They would want to make sure that they are not spending too much money on one product because if the ATC is 1$ more than the price for a unit then the firm is making a loss of 1$.

    3. What can cause a firm’s cost curves to shift up or down? How would a shift of the cost curves affect a firm’s profits?

    – The four main cost of production are what affects the cost curves. So there would need to be a change in any one of these four costs for there to be a shift in the cost curves. If the wage of labor went up or down, because of a minimum wage put into place or the cost of living goes down and you don’t need to pay the workers as much, then this would cause the curves to shift. If the property market fell and rent prices went down or the value of the land that the Firm is renting goes down then the curve will increase.

  19. Sarah Ebleon 30 Nov 2009 at 4:23 am

    4.What is the primary economic goal of firms, and how can understanding their short-run costs of production help them achieve this goal?

    The primary economic goal of firms is to maximize profits. Profit is the difference between total output and total cost. So when firms minimize their total cost and maximize their total output, then they maximize their profit. In order to do so, they need to understand their short-run costs of production. The short run is the period where all the production is being made and a short-run cost is for example, the wages for employees. A firm needs to know about their short-run costs since that's the time when they produce, so when they make their output. In order to maximize the output, they have to minimize their costs. If they succeed to do that, they maximized their profit.

  20. […] WW Blog – Diminishing Returns and graphing short-run costs (Read and respond to the discussion questions as a table group) […]

  21. Philippaon 03 Dec 2010 at 9:47 pm

    The marginal costs of production are the additional costs for each additional worker that is added. This is linked to the marginal product because MP is the additional increase in output that each additional worker adds. After a certain point, additional workers increase the total product at a decreasing rate meaning that the additional workers are bringing the efficiency of the firm down. If even more workers are added, marginal product could be negative. This is because fixed resources mean that some workers have nothing to do and just get in the way. If these workers are still getting paid for not being efficient, the firm’s costs are increasing. This is called the law of diminishing marginal returns: as additional units of a variable resource (labour) are added to fixed resources, after a certain point, the marginal product of variable resource will decline.

    Total revenue – total costs = profit. A firm’s goal is to maximize profit. If a firm can keep it’s production costs low, profit can beat its greatest. Therefore, total costs or average total cost curves are important for a firm because it wants to keep these low.

    A shift up in a firm’s cost curve would meant that rent increased, or workers demanded more wages, or that interest rates on capital increased.

    To maximize profits. If a firm can understand the law of diminishing marginal returns, more workers than needed wouldn’t be employed, therefore marginal costs wouldn’t increase rapidly. Firms need to be aware that a price for the output needs to be set above the average total cost in order to gain a worthwhile profit.