Distinguish Between Decreasing Returns to Scale and the Law of Diminishing Returns

1 (a) Distinguish between decreasing returns to scale and the law of diminishing returns.

Decreasing returns to scale is when a given percentage increase in all factors of production will lead to a smaller percentage increase in output, thus increasing long-run costs. The law of diminishing returns states that as units of variable factors are added to a given quantity of a fixed factor, the output will eventually diminish.

In the diagram above, the MC and AVC decreases in the beginning but eventually increases as output increases. Diminishing returns only occur in the short run because they show what happens to output as a variable input is added to a fixed input. Thus, in the long run, since there are no fixed inputs, there are no diminishing returns. In the short run, there are both fixed costs and variable costs. As firms increase output by applying more units of variable factors, the average variable costs decrease because each additional unit of output can be produced with fewer units of labor. [pic 1]

[pic 2]

The diagram above illustrates the long run average total cost curve. There are decreasing returns to scale when the LRATC increases. Conversely, decreasing returns to scale occur in the long run because it shows what happens when the firm increases all factors of production, which cannot be done in the short run where there is at least one fixed factor of production. Variable costs increase as the input added is proportionally larger than the output.

[pic 3]

Farmer produces the output of Q1 in the SRATC1. In the short-run, the lowest-possible cost on SRATC is only at the point of a. Depend on the output the farmer wants to produce; farmer may increase all the variables of production. Thus, the ATC curve will shift to SRATC2, which enables farmer to produce the quantity of Q2 with lower cost. Once the farmer is on SRATC2, output can increase at the lowest possible cost until point b is reached, where the farmer once again should consider increasing farm size (going into the long run again) and switching to SRATC3.

(b) Using diagrams, compare and contrast the market structure of monopoly with that of perfect competition.

Monopoly is a market structure in which there is a single or dominating firm in the industry that has the ability to control the market in terms of quantity and thereby price. The monopoly is able to do so due to significant barriers to entry, economies of scale, and branding. Perfect competition is a theoretical market structure in which there are numerous firms that produce homogeneous product in an industry where there is assumed free entry and exit as well as perfect knowledge for consumers and producers.

[pic 4]

Both monopolies and perfectly competitive firms produce at the profit maximizing level of output, which is when MR = MC, and make abnormal profits in the short run. However, only monopolies can continue their abnormal profits in the long run. Perfectly competitive firms will make normal profit in the long run because any abnormal profits will provide an incentive for other firms to enter the industry. Since there are no barriers to entry, firms can enter freely, increasing industry supply and thus eliminating any abnormal profit made in the short run. In contrast, as monopolies have high barriers to entry, firms cannot enter freely, and any abnormal profit made can be kept. As a result, monopolies can engage in research and development with their profit. This is beneficial for the consumers because they can experience varied products, which can increase their welfare, a government priority. This is also beneficial for producers because product variety can create additional barriers to entry which can help the producers be sole providers in the industry. Another difference is that monopolies also enjoy economies of scale unlike perfectly competitive firms that are too small to have lower average costs with increasing output.