Download Law of Diminishing Returns

Agribusiness Library
Lesson 060103 Law of Diminishing Returns
1
Student Learning Objectives
1. Explain the production function, and define
related terms.
2. Identify the three stages of the production
function, and describe the Law of Diminishing
Returns.
3. Analyze the cost of production, and define
related terms.
4. Describe the Rule of Profit, and define related
terms.
5. Define profit maximization, and determine
how much input should be used to maximize
profit.
2
Terms







average cost
average fixed cost
average product
average revenue
average variable cost
diminishing marginal
returns
fixed cost







marginal cost
marginal product
marginal revenue
production function
profit
profit maximization
revenues
3
Terms (cont’d)







Stage 1 in a production function
Stage 2 in a production function
Stage 3 in a production function
total cost
total product
value of marginal product
variable cost
4
How do producers know how much
to produce?
What are some related terms?
The production function relates the inputs
and outputs of a process that creates goods or
services.
A. Total product is the amount of product
produced given a combination of inputs.
For example, the total product on a 100-acre
farm might be 20,000 bushels
of corn (200 bu/acre × 100
acres).
5
How do producers know how much
to produce?
What are some related terms?
B. The marginal product is the additional
production from one additional unit of input.
C. There are often diminishing marginal returns
to additional inputs, which means the cost
of the additional inputs may not be worth
the end result. For example, when you are
studying, you are likely to learn the most
during the first hour. Each additional hour will
add to your learning, but it will not help as much
as the first hour. As you grow more tired, you
may stop learning entirely.
6
How do producers know how much
to produce?
What are some related terms?
D. To calculate the value of marginal product,
it is necessary to multiply the marginal product
by the price of the output.
E. The average product is simply the total
product divided by the number of inputs. For
example, if a person uses 10 bags of seed to
grow 4,600 bushels of corn, then the average
bushels of corn per bag of seed is 46.
F. When making production decisions, the value of
marginal product is the most important.
7
How do you know when to stop
adding additional inputs?
What is the Law of Diminishing
Returns?
The production function for most outputs has
three stages.
A. Stage 1 in a production function exhibits
increasing marginal returns. Each additional
unit of input yields more output than the
previous unit.
8
How do you know when to stop
adding additional inputs?
What is the Law of Diminishing
Returns?
B. Stage 2 in a production function exhibits
diminishing—but positive—marginal returns.
Therefore, total production increases with each
additional unit of input, but total production
does not increase as much as the last additional
unit of input.
9
How do you know when to stop
adding additional inputs?
What is the Law of Diminishing
Returns?
C. Stage 3 in a production function exhibits
negative marginal returns. As the variable input
used exceeds the capacity of the fixed inputs,
the output may actually begin to decline. For
example, when a person waters plants too
much, the plants drown. When this occurs,
there are negative marginal returns to watering
the plants.
10
11
How does a producer know how much it
will cost to produce a unit of output?
What are some of the common terms
associated with the cost of production?
When an individual is producing output, he or
she will have to purchase inputs. The costs of
these inputs can be measured and assigned to
each unit of output.
12
How does a producer know how much it
will cost to produce a unit of output?
What are some of the common terms
associated with the cost of production?
A. A fixed cost is a cost that is constant,
regardless of the number of units produced.
For example, if a farmer invests in an acre of
land, the cost of that land is the same whether
the farmer grows 1 bushel or 200 bushels of
corn. Total fixed cost is simply the fixed cost of
the input.
13
How does a producer know how much it
will cost to produce a unit of output?
What are some of the common terms
associated with the cost of production?
B. A variable cost is a cost that is incurred with
each unit of production. For example, the cost of
feeding a dairy cow occurs only if additional
cows are milked and additional milk is produced.
Total variable cost is
calculated by multiplying
the variable cost per unit
by the number of units
produced.
14
How does a producer know how much it
will cost to produce a unit of output?
What are some of the common terms
associated with the cost of production?
C. Total cost is the sum of fixed costs and variable
costs. Total costs measure the entire cost of
producing a given level of output.
D. Marginal cost is the cost of producing one
additional unit of output.
E. Average cost is calculated by dividing the
total cost by the number of units produced.
15
How does a producer know how much it
will cost to produce a unit of output?
What are some of the common terms
associated with the cost of production?
F. Average fixed cost is calculated by dividing
the total fixed cost by the number of units
produced.
G. Average variable cost is calculated by dividing
the total variable cost by the number of units
produced.
16
How does a producer know how much it
will cost to produce a unit of output?
What are some of the common terms
associated with the cost of production?
H. The stages of the production function impact the
marginal, average, and total costs. Total costs
will always rise. In the first stage of production,
the marginal cost will start relatively high (due
to fixed costs), but they will drop rapidly as the
fixed costs are spread out among more units. As
production moves into Stage two, the marginal
cost curve will start to increase with each
additional unit. In Stage 3 of production,
marginal costs will rise exponentially.
17
How does a producer know how much it
will cost to produce a unit of output?
What are some of the common terms
associated with the cost of production?




Total Cost = Total Fixed Costs + (Quantity
Produced × Variable Cost)
Average Cost = Total Costs/Number of Units
Produced
Average Fixed Cost = Total Fixed Costs/Number
of Units Produced
Average Variable Cost = Total Variable
Costs/Number of Produced
18
How does a producer measure the
revenues earned from sales of output?
What are some terms associated with
the Rule of Profit?
Revenues are earned by selling outputs. The
quantity of output sold multiplied by the price
per unit will equal total revenues.
A. Marginal revenue is the price per unit earned
on the last unit sold.
B. Average revenue is the total revenue divided
by the number of units sold.
C. Profit is calculated by subtracting the total costs
from the total revenues.
19
What is profit maximization?
How should profit be maximized?
Profit maximization occurs when marginal
revenue is equal to marginal cost.
A. If a firm cannot set its own price, then the
market price will be marginal revenue.
B. In this perfectly competitive market, producers
should produce where the marginal cost of one
unit of output is equal to the market price.
C. Inputs should be used until their marginal cost is
equal to their marginal product value.
20
Review





When is the value of marginal product is the
most important?
Describe the three stages of the production
function.
How is total cost calculated? How average cost
calculated?
What is the quantity of output sold multiplied
by the price per unit equal to?
How should profit be maximized?
21