.

COST CONDITION

Certain conditions are necessary for the functioning of an efficient market:a large number
of buyers and sellers each acting independently according to their own self- interest,
perfect information about what is being traded, and freedom of entry and exit to and from
the market.

Add to this list that firms dealin identical products and that they are price takers, and
you no have perfect competition. Identical products mean that there are no real
differences in the output of firms.

They are all making and selling the same stuff. Think of things like wheat, corn, rice,
barley, and whatever else goesinto making breakfast cereal. Wheat grown by one farmer
is not significantly different from wheat grown by another farmer.

Perfectly competitive markets are whateconomists call allocatively efficient.Consumers get

the most benefit at thelowest price without creating any loss forproducers. Perfect
competition is alsoproductively efficient because in the longrun, firms produce at the lowest
total cost perunit.

Economists refer to firms as pricetakers when a firm does not set the price of its output
but instead sells its output at the market price. Remember, one outcome when markets
have many different small buyers and sellers is that none are able to influence the price of
the product.

How does a farmer determine how much fertilizer to use? How many baristas are needed in a
cafe? In this lesson you will learn how the law of diminishing returns impacts expected output
per unit of input.

Law of Diminishing Returns Defined

The law of diminishing returns, also referred to as the law of diminishing marginal returns,
states that in a production process, as one input variable is increased, there will be a point at
which the marginal per unit output will start to decrease, holding all other factors constant. In
other words, keeping all other factors constant, the additional output gained by another one unit
increase of the input variable will eventually be smaller than the additional output gained by the
previous increase in input variable. At that point, the diminishing marginal returns take effect.

A Farmer Example of Diminishing Returns

Consider a corn farmer with one acre of land. In addition to land, other factors include quantity
of seeds, fertilizer, water, and labor. Assume the farmer has already decided how much seed,

water, and labor he will be using this season. He is still deciding on how much fertilizer to use.
As he increases the amount of fertilizer, the output of corn will increase. It may also reach a point
where the output actually begins to decrease since too much fertilizer can become poisonous.
The law of diminishing returns states that there will be a point where the additional output of
corn gained from one additional unit of fertilizer will be smaller than the additional output of
corn from the previous increase in fertilizer. This table shows the output of corn per unit of
fertilizer.

As the farmer increases from one to two units of fertilizer, total output increases from 100 to 250
ears of corn. Therefore the marginal, or additional, ears of corn gained from one more unit of
fertilizer is 150 (250 - 100). From two to three units of fertilizer, the total output increases from
250 to 425 ears of corn, a 175 marginal increase.
At what point does the law of diminishing returns set in? Look for the point at which the
marginal increase is at the highest point and the next marginal increase is less. In this example,
that occurs after the farmer adds the third unit of fertilizer. At three units, the marginal output in
ears of corn is 175, but when the fourth unit is added, the marginal output drops to 125.
Again, this does not mean the total production starts to decrease. In fact, the total production is
still increasing, as shown in the total ears of corn column. Also note that at the sixth unit of
fertilizer, the farmer starts to experience negative returns, where the increase in fertilizer actually
decreases the total output and the marginal output becomes negative.

A Caf Example of Diminishing Returns

We have all been to a caf where they consistently seem slammed with customers in the
mornings and wonder why they don't schedule more employees for that shift. Assuming the caf
cannot increase in size to serve the customers, it has to rely on operating at an efficient point
given the input factors that can be easily adjusted. In this case, the input factor that can change in
the short run is labor.

This chart shows the total cups of coffee served and marginal coffees served as they increase the
number of workers. At what point does the law of diminishing returns set in? Does this situation
also experience a decrease in returns? If so, at what point and why do you think that occurs?

After the fourth employee is added, the law of diminishing returns sets in. With four employees,
they serve 350 coffees; with five, 425. Even though the output still increases, the marginal
increase from four to five employees is only 75 cups of coffee; from three to four employees, the
marginal increase is 125.
To unlock this lesson you must be a Study.com Member. Create your account