  Wednesday  December 8, 2021
 AmosWEB means Economics with a Touch of Whimsy! RATE OF RETURN: The ratio of the additional annual income or profit generated by an investment to the cost of the investment. Here's a simple example, although the calculations are usually a great deal more involved for actual investments. If the cost of constructing a new factory is \$10 million and it gives you an extra \$1 million in profit each year, then its rate of return is 10 percent.                              MARGINAL COST AND LAW OF DIMINISHING MARGINAL RETURNS:

Decreasing then increasing marginal cost, reflected by a U-shaped marginal cost curve, is the result of increasing then decreasing marginal returns. In particular the decreasing marginal returns is caused by the law of diminishing marginal returns. As such, the law of diminishing marginal returns affects not only the short-run production of a firm but also the cost of short-run production. This translates into a positively-sloped supply curve for profit-maximizing competitive firms.
The marginal cost incurred by a firm in the short run are guided by the same principles that guide short-run production, especially the law of diminishing marginal returns. As the marginal product of the variable input decreases, due to the law of diminishing marginal returns, a firm must hire increasingly more of the variable input to get the same increase in output. This means that the incremental cost of producing an additional unit of output increases. In other words, decreasing marginal returns causes increasing marginal cost.

The marginal product and associated marginal cost of producing Wacky Willy Stuffed Amigos (those cute and cuddly armadillos and tarantulas) can illustrate this relation.

### Stage I: Increasing Marginal Returns

In production Stage I, with increasing marginal returns, marginal cost declines. Because each additional worker is increasingly more productive, a given quantity of output can be produced with fewer variable inputs. Consider an extreme example.
• Suppose that the first worker employed by The Wacky Willy Company has a marginal product of one Stuffed Amigo and is paid \$5 an hour. In this case, the marginal cost of producing the first Stuffed Amigo is \$5. One worker, working one hour, produces one Stuffed Amigo, and the cost is \$5.

• Now suppose, with increasing marginal returns, that the second worker has a marginal product of 2 Stuffed Amigos, but is paid \$5 per hour like the first worker. In this case, the marginal cost of producing the second Stuffed Amigo is only \$2.50. With a greater marginal product, the second worker needs to work only half-an-hour to produce one Stuffed Amigo, at a marginal cost of \$2.50. One worker, working half-an-hour, produces one Stuffed Amigo, and the cost is \$2.50.
The bottom line: With an increasing marginal product, marginal cost decreases.

### Stage II: Decreasing Marginal Returns

In production Stage II, with decreasing marginal returns, marginal cost increases. Because each additional worker is less productive, a given quantity of output needs more variable inputs. Consider what happens as The Wacky Willy Company produces enough to succumb to the law of diminishing marginal returns.
• Suppose that the 101st worker employed by The Wacky Willy Company has a marginal product of 10 Stuffed Amigos and again is paid \$5 an hour. In this case, the marginal cost of producing the one Stuffed Amigo is \$0.50. One worker, working one-tenth of an hour, produces one Stuffed Amigo, and the cost is \$0.50.

• Now suppose, with decreasing marginal returns, that the 102nd worker has a marginal product of 5 Stuffed Amigos, but is also paid \$5 per hour like the other workers. In this case, the marginal cost of producing the one Stuffed Amigo is only \$1. With a declining marginal product, the 102nd worker needs to work one-fifth of an hour to produce one Stuffed Amigo, at a marginal cost of \$1.
The bottom line in this case: With a decreasing marginal product, marginal cost increases. The prime conclusion is that the positively-sloped portion of the marginal cost curve is directly attributable to the law of diminishing marginal returns.

 <= MARGINAL COST MARGINAL COST AND MARGINAL PRODUCT => Recommended Citation:

MARGINAL COST AND LAW OF DIMINISHING MARGINAL RETURNS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2021. [Accessed: December 8, 2021].

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