01. Law of Diminishing Returns

01. Law of Diminishing Returns - Law of Diminishing Returns...

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Law of Diminishing Returns For a variety of reasons, a large number of students find this material difficult. It is the foundation of all economic analysis of market processes. It is the reason why supply curves slope upward and (at least, some would say) why competition and markets exist. Do yourself a favor and work through this. Then come to class and work through it again until you understand it and the graphics come easy to you. A. Diminishing Returns: An Underlying Story Outputs are produced by combining inputs. Anything that is produced requires space (e.g., a factory or plant), materials, labor, and machinery. A simple story to describe this process is that a firm first builds a plant, then equips it with machinery, then hires a work force, and then arranges for a steady flow of materials. Finally, it uses the labor and machinery to transform the flow of materials into a corresponding flow of marketable output. Notice that I have not mentioned the word “money”. Get the real version straight before we talk about money and finances. Note the inputs (plant and machinery, materials and labor). Note the sequence: plant and machinery first (“capital”), followed by materials and labor. Once you build your plant and equip it with machinery, you may start operating. Once you start operating, you cannot change the size of your plant or modify your machinery without shutting down temporarily. For this reason, the plant and machinery are commonly associated with “fixed costs” and the labor and materials are “variable costs”. Now we can discuss the money and consider finances in terms of monthly payments. Imagine that the plant and machinery costs $50,000. The firm takes out a loan and finances it for $1000 a month; make that an interest-only loan to keep things simple. That 1000 is the fixed cost (FC). Note that the firm doesn’t have to buy its plant and equipment. Renting it works just as well, the main difference being that financing comes from a landlord instead of a bank. 1
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This note was uploaded on 05/09/2008 for the course ECN 212 taught by Professor Nancy during the Fall '07 term at ASU.

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01. Law of Diminishing Returns - Law of Diminishing Returns...

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