Explain the difference between Law of diminishing returns and economies of scale (10)
These are economic theories that influence cost in the short run and long run respectively.
- Define SR/LR.
- Short run: time period where at least 1 FOP is fixed
- Long run: time period where all FOP are variable
- Define LDMR & EOS
- LDMR states that in the short run, as more and more variable factors are added to a fixed FOP, there comes a time where each unit gives less return than the previous one
- Explain different cases for both- LDMR occurs only in short run when variable factors are added to fixed factor. Give examples, such as using labor to a fixed machinery, overcapacity might occur and each unit gives less return that the previous unit, ie marginal product is decreasing with output. This means that marginal costs are rising, it costs more to buy each additional output. This is illustrated in diagram below.
On the other hand, economies of scale refer to a decreasing of long run average costs when a firm increases output. This is due to increasing returns to scale, for example marketing EOS, technical EOS. This happens at a time period where all FOP are variable. For instance, when a firm gets larger, it can afford better equipment and machines that are more productive and efficient. Hence, average cost is reduced.
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