Here is a noneconomic example of a hypothetical relationship between "inputs" and "output" that may help you better understand the idea of diminishing returns. Suppose that: Total Attractiveness = f (Physical Features; Personality, Clothing, and Perfume/Cologne) where f means "function of" or "depends on." So this hypothetical relationship supposes that total attractiveness depends on physical features, personality, clothing, and the amount of perfume or cologne used. For analytical purposes, let’s assume that one’s physical features, personality, and clothing are fixed. Now let’s add units of perfume or cologne to "produce" greater attractiveness. The first dab of perfume or cologne increases total attractiveness. Will the second dab enhance attractiveness by as much as the first? By how much will the third, fourth, fifth … thirty-fifth dab contribute to total attractiveness relative to the immediate previous dab? We think you will agree that eventually diminishing returns will set in as successive dabs of perfume or cologne are added. At some point the marginal product of extra dabs of perfume or cologne will decline, and at some further point, it will become zero. Thereafter, an extra dab of perfume will reduce total attractiveness. So it is with production relationships within firms. As successive units of a variable input (say, labor) are added to a fixed input (say, capital), the marginal product of the variable input eventually will decline. In short, diminishing returns eventually will occur. Total product eventually will rise at a diminishing rate, reach a maximum, and then decline.

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9.2 Marginal and average cost button

A second, weightier example might help you remember the relationship between average total cost and marginal cost. Suppose there are 40 students in your economics class and their total weight is 6,000 pounds. What is the average weight? The answer, of course, is 150 pounds (= 6,000/40). This average weight is analogous to average total cost (ATC). Both averages are found by dividing the respective totals (total weight or total cost) by the number of units (students or quantity). Suppose that on the second day of class a horserace jockey weighing only 100 pounds enrolls. What happens to the average weight of the class? Because her marginal weight of 100 pounds is less than the 150-pound average weight, the average weight falls to 148.8 pounds. So it is with marginal cost and average total cost. When marginal cost is less than average total cost, ATC falls. Next, suppose that on the third day of classes a 350-pound sumo wrestler enrolls. Because his marginal weight of 350 pounds exceeds the average weight of 148.8 pounds, the average weight rises to 153.6 pounds. This, too, is like the relationship between marginal cost and average total cost. When marginal cost exceeds average total cost, ATC rises. Observe in the text figure that average total cost is falling when the marginal cost curve is below the average total cost curve and that average total cost is rising when the marginal cost curve is above the average total cost curve.

9.3 Minimum efficient scale button

There are only three manufacturing plants in the United States that provide final assembly to large commercial aircraft. All three are owned by Boeing and are located in just two states: California and Washington. Each plant is enormous, employing tens of thousands of workers. The three plants together produce about half the large commercial aircraft sold worldwide, with the European company Airbus producing the other half. In contrast, hundreds of separate firms in the United States operate more than a thousand plants that produce ready-mixed concrete (hereafter, just "concrete"). All cities and large towns have one or more such plants. Why are there so few commercial aircraft plants and so many concrete plants? The simple answer is that minimum efficient scale (MES)—the smallest plant size at which minimum per-unit costs can be achieved—is radically different in the two industries. There are two reasons why. First, economies of scale are extensive in assembling large commercial aircraft and modest in mixing concrete. Manufacturing airplanes is a complex process that requires large facilities, thousands of workers, and very expensive, specialized machinery. The Boeing 747 plant in Washington State, for example, is the world’s largest building in terms of total volume. Economies of scale extend to huge plant sizes. But mixing Portland cement, sand, gravel, and water efficiently to produce concrete requires only a handful of workers and relatively inexpensive equipment. Economies of scale are exhausted at relatively small plant sizes. The second reason for the differing MESs derives from the different sizes of the geographical markets in the two industries. The market for a commercial aircraft plant is the entire globe; the market for a concrete plant is roughly a 50-mile radius from the plant. Aircraft manufacturers deliver new airplanes to anywhere in the world simply by flying them there. Concrete producers deliver ready mixed concrete to customers by truck. The rotating drums on the trucks inhibit the concrete from "setting up," but only for a limited length of time. Concrete producers therefore must place their plants relatively close to their customers. Because potential customers are clustered in hundreds of different towns and cities in the United States, there are thousands of small concrete plants. Two or three such producers typically compete within each geographical market.

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