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What is the Law of Increasing Costs?

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  • Last Modified Date: 17 September 2016
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The law of increasing costs, a commonly held economic principle, states that an operation running at peak efficiency and fully utilizing its fixed-cost resources, will experience a higher cost of production and decreased profitability per output unit with further attempts at increasing production. To maximize profits and reduce inefficiency, business owners and managers try to use all factors of production at full capacity. At a certain productivity level, the company achieves maximum efficiency of output with a fixed amount of overhead and expense. In order to increase production further, the company will have to increase its costs by adding more equipment, labor, and materials. Subsequently, according to the law of increasing costs, the production cost for each additional unit increases and the profit margin narrows.

Marginal costs are the additional costs incurred when the quantity produced changes by one unit. When the marginal cost curve increases, the average total cost rises. In order to maintain the same level of profit, the company has to raise the price for the product. A change in price acts as a shift factor to drive down market demand for the product. As the demand drops and the supply increases, the market will no longer sustain the higher price, leading to a reduction in company profitability.

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Some market factors, however, can make the law of increasing costs inapplicable. These shift factors can influence either product demand or supply. Anything that drives up the demand for a product or drives down the supply will tend to buffer a company from the negative effects of increasing production costs. Typical demand shift factors that help counteract the law include increasing consumer income levels, increasing interest in the product, increasing numbers of consumers, or increasing competitor prices. Supply shift factors that counterbalance increasing marginal costs include competitors going out of business and increased product utilization due to a war, natural disaster, or other event.

In addition to the law of increasing costs, company managers must also consider the law of diminishing returns. The law of increasing costs states that as additional inputs of a given production factor, such as equipment or labor, are added into an operation,the benefits reaped get progressively smaller if the other factors are held constant. An illustration of this principle would be the addition of workers on a farm. Initially the extra work force increases the harvest, but eventually there is not enough land or equipment available to make full use of each worker. This leads to a reduction in overall efficiency of the company.

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lita1104
Post 4

@donasmrs: Not necessarily. If a firm is in the increasing cost range of the cost curve, increasing production by an additional unit will decrease the profit on that unit. The firm will still make profits, but cost is increasing at an increasing rate at that point so the per unit profit on each additional unit will be decreasing.

At that point, the firm should increase its plant size in order to maintain the profit maximizing level of output.

All of this depends on some strong assumptions and actually depends on the scenario. There are 2 ways to look at increasing costs from an economics perspective, and my response is premised on what I thought were your assumptions.

I would be happy to break it down further if you're interested.

From a temporarily out of work (due to an injury) econ prof who is anxiously looking forward to getting back in the classroom!

candyquilt
Post 3

Both the law of increasing costs and diminishing returns come down to limited resources. Because resources are limited, more production means increasing costs and diminishing returns.

The farmer's land example is always given in my economy courses to explain these laws. But it applies to more than just employment. For example, a company that builds residences will face these problems when construction homes on limited acreage.

bear78
Post 2

@donasmrs-- Not necessarily. From what I understand, the law of increasing costs is generated by the cost of additional equipment and forced change in prices. It says that if you are using all of your equipment at maximum capacity, you cannot increase production without additional costs.

But this doesn't mean that you shouldn't grow your business further. It just means that you cannot avoid higher costs if you decide to do so.

Let's say that you're the only business in town that provides a certain good. Even if your costs increase and you reflect this to the consumer as higher prices, the consumer will probably continue to buy from you.

But if there are ten other business that sell the same thing and you increase prices, your profit will certainly decrease.

donasmrs
Post 1

What should I infer from the law of increasing costs? Should a business at peak efficiency avoid further growth to avoid increasing costs?

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