Explain How A Firm Can Experience Diminishing Returns in the Short Run and Economies of Scale in the Long

Run (15 marks)

The short run is a period of time in which at least one factor of production is fixed, whilst others are variable. The long run is a period of time in which all factors of production are variable.

Costs

Output

The law of diminishing returns for a firm, in relation to cost is when the average cost and marginal cost fall then stabilise and then begin to rise. The circled area on the diagram shows where the diminishing returns occur on the average cost curve. Its just after the marginal cost curve intersects the average cost curve at its lowest point. This is where average cost begins to rise. For the marginal cost curve, the diminishing returns occur slightly beforehand, (circled on the diagram) as this is where the marginal cost begins to rise. If a factor decides to employ an extra worker, their total costs go up, however, the worker will increase output so thus their average cost would be reduced as Average Cost= Total Cost/Output. The factory may employ another worker who increases output, but not by as much as the first worker, thus the decrease in average cost wont be as much as the first worker. So therefore, the average cost has begun to stabilise. If the factory then decides to employ another worker, who fails to increase output at all, then total cost goes up, and since theres no increase in output, average cost also goes up. This is a diminishing return. Economies of Scale are when the cost per unit of output falls as the scale of production increases. If a firm has spare capacity, then it can increase employees to increase output. However, the firm will eventually reach a point where they cant increase output solely by increasing employees; this is marked by point C on the diagram, which is on the LRAC, and on SRAC1. At this point is where the firm will move into the long run, they will do this by changing another factor of production. They could expand by increasing their fixed capital. By changing more than one factor of production at the same time, the firm moves into the long run. By increasing fixed capital, they can increase the scale of their production, and thus massively increase output, which will largely reduce their average cost, this is marked as

point D on the LRAC curve, but it is on the SRAC2 curve. Fixed capital is generally plant equipment and machinery. This is a technical economy of scale.