Diminishing Returns and U-Shaped Cost Curves

The relationship between cost and production helps us explain why average cost curves tend to be U-shaped.
Recall that Chapter 6’s analysis of production distinguished two different time .periods, the short run and the long run. The same concepts apply to costs as well:

The stalwart run is the period of time that is long enough to adjust variable inputs, such as materials and production labor, but too short to allow all inputs to be ‘changed. In the short run, fixed or overhead factors such as plant and equipment cannot be fully modified or adjusted. Therefore, in the short run, labor and materials costs are typically variable costs, while capital costs are
fixed.

In the long run, all inputs can be adjusted-ineluding labor, materials, and capital. Hence, in the long run, all costs are variable and none are fixed.Note that whether a particular cost is fixed or variable depends on the length of time we are considering. In the short run, for example, the number of planes that an airline owns is a fixed cost. But over the longer run, the airline can clearly control the size of its fleet by buying or selling planes. Indeed, there is an -active market in used planes, making it relatively easy to dispose of unwanted planes. Typically, in the short run, we will consider capital to be the fixed cost and labor to be the variable cost. That is not always true (think of your college’s tenured faculty), but generally labor inputs can be adjusted more easily Thar can capital. Why is the .cost curve V-shaped? Consider the short run in which capital is fixed but labor is variable. In such a situation, there are diminishing returns to the variable factor (labor) because each additional unit of labor has less capital to work
with. As a result, the marginal cost of output will rise because the extra output produced by each extra labor unit is going down. In other words, diminishing returns to the variable factor will imply an increasing short-run marginal cost. This shows why diminishing returns lead to rising marginal costs after some point.

Figure 7-4, which contains exactly the same data as Table 7-4, illustrates the point. It shows that the region of increasing marginal product corresponds to falling marginal costs, while the region of diminishing returns implies rising marginal costs. We can summarize the relationship between the productivity laws and the cost curves as follows: In the short run, when factors such as capital are fixed, variable factors tend to show an initial phase of increasing marginal product followed by diminishing marginal product. The corresponding cost curves show an initial phase of declining marginal costs, followed by increasing Me after diminishing returns have set in.

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