Question

Explain the difference between the law of diminishing returns and economies of scale. How does the law of diminishing returns effect the average total cost curve? What are economies of scale (also called increasing return to scale) and diseconomies of scale (also called decreasing return to scale), and how do they effect the average total cost curve?

Answer 1

As per law of diminishing returns, when more of a variable input gets added to production, output increases up to a certain point after which each additional unit of the input leads to a lower increase in output, therefore output increases at a decreasing rate, exhibiting diminishing marginal product (MP) of the variable input. When law of diminishing returns starts, MP starts to decreasing, so MP curve starts sloping downwards. In this range, ATC curve is upward rising.

Economies of scale exists when with increase in output, average total cost (ATC) keeps decreasing, so the ATC curve is downward sloping. Diseconomies of scale exists when with increase in output, average total cost (ATC) keeps increasing, so the ATC curve is upward rising.