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Distinguish between the law of diminishing returns and returns to scale.

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  • October 28, 2003
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The law of diminishing returns only applies in the Short Run, when only one factor of production is variable and can be increased. The other factors of production are fixed. Thus as the variable factor of production is increased the marginal product of that factor will rise at first, but will at some point begin to fall.

Returns to scale can only occur when no factors of production are fixed. If the quantities of all of the factors of production are increased, then output will also increase. However, the amount by which output rises can either be proportionately more than the amount that the factors of production were increased by, proportionately less, or the same. These cases are called increasing returns to scale, decreasing returns to scale, or constant returns to scale.

The law of diminishing returns is also called the law of variable proportion, as the proportions of each factor of production employed keep changing as more of one factor is added. In a factory, the factor of production most easily varied is labour. Thus when the factory needs to increase output quickly it is likely to take on more workers. This will lead to the marginal product rising at first, because each additional worker will increase output by more than they increase the firms' costs. However eventually there will be too many workers, and too few machines for them to use. This means the marginal product will fall, and the firm is not producing efficiently.

When the firm needs to increase its production by more than the amount available by varying one factor, it needs to also vary the other factors. The firm would need to buy more land, capital, enterprise and labour; that is increase all of the factors of production, which is only possible in the long run. As the firm increases in size, it will achieve increasing returns to scale, or economies of scale, for several reasons.

Technical economies of scale occur because some factors of production are indivisible, such as...