When a manager of a small business has to determine its production schedule, it is unlikely that she draws cost curves and ponders how diminishing returns affects a J-shaped graph. Nonetheless, businesses unknowingly incorporate the law of diminishing returns in their decision-making. Diminishing returns affects a company’s variable cost curve in several ways.
Identification: Diminishing Returns
“Diminishing returns” is an economic term that relates to the reduced benefit from producing or consuming a good over time. Simply put, people gain significantly less pleasure from eating their fifth helping of mashed potatoes than they do from eating their first serving. Likewise, if demand for a product is 50 units per month, companies gain fewer returns by manufacturing 1,000 products for the month instead of producing just 75.
Identification: Cost Curves
In economics, cost curves exist as variable and fixed costs. Economists also measure short and long-term cost curves, which differ subtly from the other. William Baumol, author “Economics: Principles and Policy,” states how these curves reflect the cost of producing a good over time. When a company gains proficiency at producing an item the cost of production declines. However, the cost of producing an item increases if the company manufactures items in excess of consumer demand. This is why the cost curve is “J” or “U” shaped: The cost of production dips when it achieves economies of scale, and rises when the company produces goods in excess of demand.
Economists use the law of diminishing returns to analyze cost curves. Because consumers only desire to consume a certain quantity of the firm’s goods, the business must assess how much of a good to produce. For instance, if consumers demand 50 cupcakes in a given day, the company gains the most economic profit when it produces near this amount. The company will sit on the lowest point of the variable cost curve because its production is most efficient. If the company produces 400 cupcakes, the company’s point on the cost curve shifts higher because its production is inefficient. As explained by Maureen Hoag in the textbook, “Introductory Economics,” the reason the variable cost curve slopes upward past the point of achieving economies of scale is because of the law of diminishing returns.
Calculating the diminishing returns and its effects on the cost curve is much easier for economics students who are given complete, hypothetical information regarding costs and demand. Businesses must work with incomplete information. Nonetheless, businesses attempt to gauge the relationship between diminishing returns and its cost curves in order to assess consumer demand and determine its production schedule. Inefficient production is a reason why some companies go out of business. If its cost of production is significantly higher than other businesses, the company cannot be competitive. Even if the business’s inputs are less expensive and its labor costs are lower, failing to account for the law of diminishing returns and inaccurately assessing demand will cause the company to perform poorly.