4.3 The law of diminishing returns and returns to scale

What is the difference between the short run and long run?

The short run is defined as the time period in which at least one one of the factors of production is fixed and cannot be varied. By contrast, the long run is defined as the time period in which the scale of all the factors of production can be changed.

Define the law of diminishing returns

A short term law which states that as a variable factor of production is added to a fixed factor of production, both the marginal and eventually the average returns to the variable factor will begin to fall.

Define marginal returns of labour

The change in the quantity of total output resulting from the employment of one more worker, holding all the other factors of production fixed

Law of diminishing returns shown on diagram

page 84

Define total returns

The whole output produced by all the factor of production, including labour, employed by a firm

Define average returns of labour

Total output divided by the total number of workers employed

What is the difference between marginal and average returns?

Whereas marginal returns are the addition to total output attributable to taking on the last worker added to the labour force, the average returns at any level of employment are measured by dividing the total output of the labour force by the number of workers employed.

Define returns to scale

The rate by which output changes if the scale of all the factors of production is changed

Define increasing returns to scale

When the scale of all the factors of production employed increases, output increases at a faster rate

Define constant returns to scale

When the scale of all the factors of production employed increases, output increases at the same rate

Define decreasing returns to scale

When the scale of all factors of production employed increases, output increases at a slower rate

Example of returns to scale

Suppose that a firm's fixed capital is represented by plant size 1 in the diagram (page 83). Initially, the firm can increase production in the short run, by moving along the horizontal arrow A, employing more variable factors of production such as labour. To escape the impact of short run diminishing marginal returns which eventually set in, the firm may make the long run decision to invest in a larger production plant, such as plant size 2. The movement from plant 1 to plant 2 is shown by the movement along the vertical arrow X in the diagram. Once plant size 2 is in operation, the firm is in a new short run situation, able to increase output by moving along arrow B. But again, the impact of short run diminishing returns may eventually cause the firm to expand the scale of its operation again in the long run.