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.