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JA3. Law of Diminishing Returns

Statement

Please explain why the law of diminishing returns applies only in the short-term period.

Answer

The law of diminishing returns states the marginal product of any variable factor of production will decline as we add more of that factor to another fixed factor, that is, every added unit of the variable factor will add less and less to the total output (Rittenberg & Tregarthen, 2009).

The law is logical as factors of production are mixed together to produce every single unit of output, that is, every factor of production is involved in the production of every unit of output. Thus, with adding more of the variable factor, it is going to be mixed with more of the fixed factor, until the fixed factor is fully utilized and the newly added units of the variable factor have no fixed factor units to work with, thus it can not produce any output.

As an example, let’s think of a factory with a 25m area, it uses machines that each needs 5m area and produces 10 units of output. The factory land is a fixed factor and a machine is variable one. The factory starts with 3 machines, and output is 30; adding two more machines will increase the output to 50. But if we add more machines, there is no space for them; we can make space by reducing spaces between machines, but this will reduce overall productivity as workers have less space to move around.

If there was no fixed factor, and we are free to change all factors of production, then there is unlimited factors and unlimited output, that is, for the additional units of one variable added, we can add more of the other variable factors to keep the output increasing. In the example above, if the land was not fixed, which means we can expand the factory, then we can add more machines and add required space for them, and thus output will keep going up.

The short-term period (or short run) is defined as a period in which at least one factor of production is fixed. The long-term period (or long run) on the other hand accepts all factors of production as variables. We have proven that the law of diminishing returns applies only in the case of at least one fixed factor, so it only applies in the short-term period (Banks, 2014).

In short term, a firm is limited by its flexibility and ability to respond to changes, thus short-term planning requires considering some factors as fixed, so the planing can be more achievable and realistic. Things like land, capital, and technology are considered fixed in the short-term, as changing any of them requires a long time and a lot of resources.

In the long-term, a firm has more flexibility, time, and ability to change all factors of production, thus it can avoid the law of diminishing returns while planning assuming that they can add as much as required of any factor.

Indeed (2024) lists a few causes for the law of diminishing returns, including the limited nature of the fixed factor, overcrowding of labor decreases productivity, demand pressure does no allow for infinite productivity, a production site has an optimum capacity that can not be exceeded, and the law only applies in the short-term period.

To conclude, the law of diminishing returns applies only in the short-term period because it is based on the assumption that at least one factor of production is fixed. The absence of the law in short-term means that production can be increased without limit which is not practical. On the long-run, firms have more time and resources to bring any factor of production to the required level, thus they can avoid the law of diminishing returns (to practical extent).

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