The law of diminishing marginal returns states that at some points in the production process, adding another factor of production can lead to a relatively smaller increase in output. It is also described as a decrease in the marginal yield in production when a single factor of production is increased while the other factors of production are kept constant. (Solow 2014, p.87). It is important to consider that the law of diminishing returns have an impact on both marginal cost and average total cost.
The law of diminishing marginal return increases the marginal cost. For instance, if a factor of production like capital is increased while another factor such as labor remains constant, production in the short run will rise. The situation would results in an increase in the cost while the cost of a product would be higher in the long run.
Average total cost
It is apparent that the marginal cost has an impact on the average cost. For instance, an increase in the marginal cost will increase the average cost of production. Thus, the law of diminishing returns means that the marginal cost will increase as output is increased. Eventually, increasing the marginal cost will lead to a rise in the average total cost.
As a business expands in the long run, the average curve is attained. This is based on the economies of scale and diseconomies of scale displayed in the above curve. It is apparent that the curve of the average cost at this point is U-shaped and it consists of a series of U-shaped curves which represents the cost of the business in various sizes. According to Shepherd 2015, some benefits come into play when a business decides to get involved in large scale production. However, dis-economies of scale is known as demerits that are linked with individuals who operate small scale business as opposed to large scale.
A business can produce a unit of a product at a cheaper cost when enjoying economies of scale. However, in the diseconomies of scale, a business produces a unit of a product at a high price in the long run. The curves that slopes represent the economies of scales; meaning that the cost of production per unit is lower. Besides, Diseconomies of scale is represented by an upward sloping of the curve which means that the cost of production rises per unit output. These factors explain why the long run curve for the average cost is U-shaped.
The rule for profit maximization states that for a business to maximize its profit, it has to select a point in the production process where marginal cost equals the marginal revenue. In regards to this, a business has to produce at a point where marginal cost equals marginal revenue. To explain the concept, it is important to consider either side of the case. For instance, if the marginal cost is less compared to marginal revenue, means that to attain an additional unit output, revenue will be more compared to the cost. Thus a business will generate more whereas in the case where marginal cost is more compared to marginal revenue, for an extra unit output, the cost will be more compared to the revenue so a business will generate less.
According to Levinthal and Wu 2010, for a business to attain maximum profit, it must be able to produce at a point where the marginal cost equals marginal revenue. For example, using a case such as hours of operations in a business. One has to decide to remain open so long as the added revenue from extra hours added is higher than the cost of remaining open for more hours. Therefore, it is important for a business owner or operator to consider the case to make sure that he or she does not operate under a situation that can lower the maximum profit realization.
- Characteristics of Oligopoly market
In an oligopoly, the most important feature is the interdependence in decision making. This is because any change in price, the output will have a direct impact on the competitors (Wogrin et al. 2013, p.312). In regards to this, when British gas lowers its price in the market, then other companies such as EDF Energy, EON UK, and Scottish will consider lowering their prices as well.
- Block other businesses from entering the market
The industry of electricity and gas in the UK is controlled by organizations such as Scottish Power, British gas, and EDF energy among others. In regards to this, entry to the market is highly discouraged as a result of a high amount of capital that is needed as well as high competition which creates an unsuitable environment for a new business.
- Price and output behavior in Oligopoly
The large UK Corporations tries to fulfil the energy needs of about 52 million people. The large market gets its supplies from the six energy firms in the UK. These Corporations enjoy a state of interdependence as they control their prices and terms. It is apparent that they normally offer similar rates which reflect a zero competition. Moreover, the Corporations always have similar behaviors like changing the suppliers in the market to stabilize their operations. According to Wogrin 2013, rivals may decide to participate and work together or even fight when it gets to the extreme.
A perfectly competitive market is where many businesses in the market have infinite customers, perfect knowledge on the way the market operates and have similar products. The businesses in such markets take prices that the economy prevails to them and scarce market share and exist high liberty for businesses to come in and exit the market (Mirman, Salgueiro and Santugini 2014, p.23). In such a market, it is impossible for a business to make abnormal and supernormal profits. The case is provided in the diagram.
The high number of businesses that operate in the makes it impossible for a business to make profits that exceed the normal. For instance, the existence of high competition in the market makes it hard for businesses to thrive and make abnormal profits. Profit maximization can only occur where marginal cost equals marginal revenue. As a result, a business would only make normal profits in the long run.
Companies and the market
Most companies tend to focus more on profit. As a result of this, the companies always want to be at a point where profit is maximized. It is apparent that such a situation occurs when the marginal cost equals the marginal revenue (Shepherd 2015, p.113). However, the situation is always a changing point because of supply and demand change constantly. The changes occur in the market where the suppliers and consumers interact to attain a level that fits the needs and wants of both parties involved. Therefore, as a result of other factors that initiate these changes, a business has to consider these factors while in operation.
The market is made up of four structures which need a different strategy for suppliers to enter, compete and efficiently gain share in the market. In regards to competition, a business can be in a monopolistic, oligopoly, monopoly and perfect competition. The market structures, stated above provides an environment for business operations that suites the players or participants. For instance, a perfectly competitive market provides a platform where competitors have similar chances of survival.
Levinthal, D.A. and Wu, B., 2010. Opportunity costs and non‐scale free capabilities: profit maximization, corporate scope, and profit margins. Strategic Management Journal, 31(7), pp.780-801.
Mirman, L.J., Salgueiro, E.M. and Santugini, M., 2014. Learning in a Perfectly Competitive Market. Cahier de recherche/Working Paper, 14, p.23.
Shepherd, R. W. 2015. Theory of cost and production functions. Princeton University Press.
Solow, R. 2014. Thomas Piketty is right. Everything you need to know about capital in the twenty-first century. The New Republic, 22.
Wogrin, S., Hobbs, B. F., Ralph, D., Centeno, E., & Barquín, J. 2013. Open versus closed loop capacity equilibria in electricity markets under perfect and oligopolistic competition. Mathematical Programming, 140(2), 295-322.