Explain how the law of diminishing marginal returns works
The words ‘diminishing returns’ illustrate a market condition that is depicted by a reduction in marginal output coupled by an increase in a single factor of production while the rest of the factors of production remain constant (O’ Sullivan, et al, 2007). However, when another factor of production is added to the production process while the rest of the factors remain constant will lower the unit returns (Chapter 9: Production, 266).
For example, Dell Incorporation deals in the manufacture of computers and softwares. Dell in a production process adding a single factor such as materials results in wastage because it would be an overestimate of the consumer demand resulting in losses or cost overrun. This increases the cost of production as it becomes expensive to purchase materials (Blink & Dorton, 2007). Thus, the costs eat into the profits resulting in diminished returns. Hence, when an investment is made in the production process on one factor of production, then there results a decrease in returns because of the diminishing effect (Chapter 9: Production, 266).
The law of diminishing returns is usually found in short run production. Dell in its current market would find it difficult or the barriers of exit would deny dell the chance to exit a market thus only one factor is kept in variation to keep costs low. While at the same time, the company examines the current market state to weigh options of increasing production by increasing the factors of production resulting in a long run production. This is because the barriers preventing a company from exiting a market might be too high in comparison to costs of staying in a market (O’ Sullivan, et al, 2007). A company opts to keep a single factor of production such as capital to seek profitability while preventing cost overrun or losses. In addition, the fixed factors are because of minimizing costs may be because of volatile market changes. Moreover, the constant factors help the company to re-strategize on how it will remain profitable to seeking an alternative market (O’ Sullivan, et al, 2007). A company in a short run production cannot increase production of its goods because of the constraints that come with the costs of exit out of the market and entry into the market (Chapter 10: Costs, 304).
How the long run is cost-structure derived from the short run cost structure
In economics, short run period refers to the period where one input or factor of production is fixed whereas the other functions of production are not constant, whereas the long period refers to a period, during which all the factors of production are not constant (Blink & Dorton, 2007). For example, when a company like Nike enters into a market, all factors of production are kept varied as in the case of a long run such that the company can weigh the options of exit or entry into the market. The long run is depicted by the ability of a company to increase or reduce factors of production depending on the current market conditions. An improvement in market conditions may force Nike to increase capital to hire more labor and seek adequate space for more production of the goods or provision of services to the consumers (O’ Sullivan, et al, 2007). This is predominant in a market with many competitors and low barriers to exit and entry into a market. The presence of many competitors in the market means that no single company can influence market prices (Chapter 10: Costs, 319).
In a short run period, the need to keep one factor of production constant while the rest are varied is because of staying constant despite changes in the economic conditions. The short run is depicted by full utilization of the law of diminishing returns whereby the increase in the varied factor of production can result in substantial losses by the company. In relation to Nike, the barriers, preventing it from leaving a market such as high costs of exit might prevent it from doing so (Blink & Dorton, 2007). This might also be due to the inability to adjust its size, thus when a company keeps factors like capital varied and the rest constant, this might be due to such constraints in the market preventing it to seek a more profitable alternative (Blink & Dorton, 2007). Increase in one factor might result in losses and overrun costs or worse still the failure of a company if it had not projected such cost overruns. In a short run, the exit costs are high meaning that a single company has the ability to influence the market prices of goods in the market (Chapter 10: Costs, 321).
References
Blink, J., & Dorton, I. (2007). Economics: Course companion. Oxford: Oxford University Press.
O’Sullivan, A., Sheffrin, S. M., & Prentice-Hall, Inc. (2007). Prentice Hall economics: Principles in action. Boston, MA: Pearson/Prentice Hall.
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