Assumptions Underlying the

Law of Supply
Unit 2 - Lesson 3
Higher Level
Learning Outcomes:
● Explain the assumptions that underlie the Law of Supply
○ Law of Diminishing Marginal Returns
○ Increasing Marginal Cost
Law of Diminishing Marginal Returns
Inputs are those resources that are necessary to produce the output.

Important to understand the relationship between inputs and outputs.

Short-run:

● Period of time when at least one input cannot be changed (fixed).

● For example, if a firm wants to increase the amount of output it can hire more
workers, buy more material etc. VARIABLE INPUTS
● However, the firm cannot quickly change the size of it building or physical capital
such as machines. FIXED INPUTS

Short-run is a period of time where at least one input, usually physical

capital such as factories and heavy machinery are fixed. Cannot be
changed.
Law of Diminishing Marginal Returns
Long-run

● Period of time when all inputs (resources that are necessary to

production) are variable, can be changed.
● There are NO fixed inputs, ALL inputs are variable.
● In the long-run, firms are able to change inputs such as factories and
heavy machinery. These inputs are now variable.

Short-run is a period of time where at least one input is fixed.

Long-run is a period of time where all inputs are variable.

Note: Short and Long Run do not correspond to any specific amount of time.
This will vary from firm to firm and industry to industry.
Law of Diminishing Marginal Returns
The Meaning of Marginal Product

Total Product (TP): total amount of output produced by a firm.

Marginal Product (MP):

● the extra or additional output produced with the addition of one variable
input (labour/worker).
● MP tells us how much additional output is produced when we add one more
worker.
● Formula:
○ Marginal Product = change in TP divided by change in variable input (labour/workers)
Law of Diminishing Marginal Returns
● When 1 additional worker is added (0 - 1)
they produce 20 kilos of potatoes.
○ Worker is doing all work - ploughing, planting and
harvesting. A lot of work for one person
● When a second worker is added they share
the work TP increases to 50 kilos.
○ The MP resulting from the additional worker is 30
kilos - greater than the first 20 kilos.
● Process is repeated with the addition of the
3rd worker.

As each additional worker is added MP is

increasing. They become more efficient with
each additional worker.
Law of Diminishing Marginal Returns
Marginal Product is maximized at 3 workers.

Any additional worker added (4 - 6) the Marginal

Product begins to decrease.

● This is because each additional worker has less

and less land (fixed input) to farm. It becomes
overcrowded.

Eventually at the 6th worker the land (fixed input)

becomes so crowded that they do not contribute to
output. Hence MP = 0

This is not only true on a farm with a fixed input of land. This also occurs in
a factory.
Law of Diminishing Marginal Returns
As more and more variable units (workers) of
input are added to one or more fixed inputs
the Marginal Product of the variable input
(labor) at first increases, but at a point it will
begin to decrease.

When Marginal Product begins to decrease

and fall continuously we can say that the firm
is experiencing Diminishing Returns.

In the previous chart Diminishing Returns sets

in with the addition of the 4th worker.
Marginal Cost
Total Cost (TC): All the cost of productions
incurred by the firm.

Total Cost = Total Fixed Cost + Total Variable Cost.

Marginal Cost (MC):

● Additional Cost of producing one additional unit

of output.
● Marginal Cost= Change in Total Cost divided
by change in output.
Marginal Cost
Marginal Cost shows the additional cost arising
from producing one more unit of output.

We see as Total Product increases, Total Costs

also increase. More output involves more cost.

As Total Product increases from 1 - 3 units,

the cost to produce an additional unit (Marginal
Cost) decreases.

At a point after Total Product of 4 units, the

cost to produce each additional unit of output
begins to increase.
How is Marginal Cost related to Diminishing Returns
When Marginal Product is increasing Marginal Cost (cost to produce an
additional unit of output) is decreasing.

● When each additional worker added produces more than the previous worker (MP
increasing) the cost to produce that additional unit will decrease.
● Since workers add to costs and each worker produces more and more output.
The cost to produce the additional unit of output decreases.

When Marginal Product is at its maximum Marginal Cost is at its minimum.

● When the MP or the additional output of each worker becomes less and less, the
cost to produce each additional unit will increase.

When Marginal Product begins to fall, Marginal Cost increases.

How is Marginal Cost related to Diminishing Returns
The graph to the right depicts the relationship
described on the previous slide.

Left of the dotted line:

As MP increases or the additional output produced

with the addition of a labour increases, the cost to
produce each additional unit of output decreases.

When MP is at its maximum, MC is at its minimum.

As MP decreases as the additional output

produced with the addition of a unit of labour
decreases, the cost to produce each additional unit
of output increases.
Marginal Cost & Firm’s Supply Curve
The firm’s Supply Curve is a portion of its Marginal Cost Curve.

Firm’s earning per unit of output sold are determined by the price of the good.

The Firm will be willing and able to supply some quantity as long as long as the
price is enough to cover its costs.

Therefore we can think of the Supply Curve as showing the Price the firm is willing
to accept to produce one more unit of the good.

Shows the Price and Quantity combinations where the extra cost of producing one
additional unit of output (the marginal cost) is equal to the price of that unit.