Session 1

(HL)

10.07.2022
Irina Kovaleva
 How do economists explain the Law of
Supply?

There are а number of steps needed to explain

the Law of Supply.

1. The short run

2. The law of diminishing returns
3. Increasing marginal costs
 1. The short run
• When а firm is producing, some of its factors of production
will be fixed in the short run, i.e. the firm will not be able
to increase the quantity of certain factors quickly, even if
the price goes up and the producer wishes to produce more.
• Often the fixed factor is some element of capital or land,
but this is not always the case. It could be а type of highly
skilled labour, such as а specialist machine worker.
• Therefore, if а firm wishes to increase output in the short
run, it may only do so by applying more units of its variable
factors to the fixed factors that it possesses, while it plans
ahead to change the number of fixed factors that it has.
 1. The short run
• The length of the short run for а firm will by determined by the time it
takes to increase the quantity of the fixed factor. This will vary from
industry to industry.
• For example, а small firm involved in gardening may find that its fixed
factor is the number of lawn mowers that it has available and that it
takes а week to order and get delivery of а new lawn mower. Thus, its
short run is one week.
• On the other hand, а national electricity provider is constrained by its
fixed factor, the number of electricity generating plants that it has.
Building а new electricity generating plant may take up to two years
(more if а nuclear plant is built) and so its short run is а lot longer.
(71) Short run versus long run | Economics vi
deos | economics notes - YouTube
 2. The law of diminishing returns

In the short run, if а firm increases output by

adding more and more units of а variable factor
to its fixed factors, it is logical to assume that the
output from each unit added will eventually fall.

To understand this fully, we need to consider the

concepts of total, average and marginal product.
 2. The law of diminishing returns
• Total product (ТР) is the total output that а firm produces, using
its fixed and variable factors in а given time period. As we have
already said, output in the short run can only be increased by
applying more units of the variable factors to the fixed factors.
• Average product (АР) is the output that is produced, on average,
by each unit of the variable factor. MР = ТР/V, where ТР is the
total output produced and ∆V is the number of units of the
variable factor employed.
• Marginal product (МР) is the extra output that is produced by
using an extra unit of the variable factor. МР = ∆ТР/∆V, where
∆ТР is the change in total output and ∆V is the change in the
number of units of the variaЬle factor employed.
(71) Fixed/Variable/Total Costs and the Margi
nal Cost of Production Defined & Explained i
n One Minute - YouTube
For example, а firm
has four machines
(fixed factors) and
increases its
output by using
more operators to
work the
machines.
Production figures
for each week are
given in tаble.
We can plot the ТР, АР and МР figures to produce
curves as in figures.
 2. The law of diminishing returns
• From the table, we can deduce the following definitions.
• The hypothesis of eventually diminishing marginal returns - as
extra units of а variable factor are added to а given quantity of а
fixed factor, the output from each additional unit of the variable
factor will eventually diminish.
• The hypothesis of eventually diminishing average returns - as
extra units of а variable factor are added to а given quantity of а
fixed factor, the output per unit of the variable factor will eventually
diminish.
• The two hypotheses look at the same relationship from different
angles. The whole concept is really а matter of common sense.
 2. Example
• А young entrepreneur named Ben sets up а new business, which is а
small hamburger stand on а busy street corner.
• The stand consists of а very small shop, containing а refrigerator, а
grill and some countertops for preparing the burgers.
• There are also the implements for making burgers.
• These are all the fixed factors.
• When he starts out, Ben works alone and prepares everything
himself.
• He makes the burgers, cuts the onion, lettuce and tomatoes, heats the
buns, and sells the hamburgers to the customers.
• He can make 20 burgers per hour.
 2. Example
• Ben finds demand to be high and he cannot make enough burgers,
so he hires his friend, Caroline, to help.
• They divide up the jobs and manage to produce 50 burgers each
hour.
• The hamburgers become even more popular and Ben and Caroline
agree that they need another worker, so Nick joins them.
• They divide up the work again, with each specializing in а task,
and produce 90 burgers each hour.
• Demand continues to rise, so they bring in Niki.
• With the four working together, they produce 124 burgers per
hour.
 2. Example
• When Ben worked alone, his output was 20 burgers per hour.
• When Caroline joined him, the total output was 50 burgers per hour. This means
that Caroline's marginal product was 30 burgers.
• When Nick joined, the total number of burgers per hour rose to 90, so Nick’s
marginal product was 40 burgers.
• When Niki joined (we are adding units of а variable factor), the total output of
burgers rose to 124 per hour, making the marginal product 34 burgers.
• Note that the marginal product fell when Niki was added to the workforce.
• Was this because Niki was inefficient? No. So why was this?
• Well, it was efficient to add extra people up to three workers, but because the
space in the shop, the counter tops, and the grill, are all fixed, it became less
efficient when there were more people. They started to get in each other's way and
so could not increase the output of burgers by as great an amount as when the
previous worker was added.
 2. The law of diminishing returns

Whether we measure it from the amount added by

the extra variable factor (marginal product) or the
amount added per unit of the variable factor
(average product), logic tells us that inefficiency
must eventually begin to occur.
(71) The Law (or Principle) Of Diminishing
Marginal Returns (or Productivity) Explained
in One Minute - YouTube
 3. Increasing marginal costs
• Marginal cost (МС) is the increase in total cost of
producing an extra unit of output.

• where ∆TC is the change in total cost and ∆q.

• ∆q is the change in the level of output.
• If we add some costs to the example from tаblе, then we can
identify what happens to marginal cost as output increases.
 3. Increasing marginal costs
• If the output produced by each additional worker (МР)
begins to fall, yet each worker costs the same, then the cost
of producing each extra unit (МС) begins to increase.
• We can see that, because of the law of diminishing returns, as
output increases, marginal costs will begin to increase also.
• It therefore follows that firms will only by prepared to supply
more and increase output, if the prices that they will
receive for their products are also going up as output
increases.
• That way, the firms will be able to cover their marginal costs
with the price.
(71) Increasing Marginal Costs - YouTube
Law of Supply
https://www.youtube.com/watch?v=JEJW8HGPS4
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