OCR A Level Economics: Short-run costs: diminishing returns and cost curves (H460)

This guide covers the cost statements in Component 1, Microeconomics, of the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. They sit under the topic on market structures and their implications for the way resources are allocated. The whole specification is A Level, with no content labelled AS or A. All firms, figures and years below are invented for illustration. Course pages: the hub and the checklist. The matching revision notes and practice questions go with this page.

What this unit covers

Specification statement	Where it is taught
Distinguish the short run and long run in terms of fixed and variable factors	Short run and long run
Explain the law of diminishing returns	Section on the law itself
Evaluate the significance of the law of diminishing returns	Evaluating its significance
Explain what is meant by TC, TFC, TVC, AC/ATC, AFC, AVC and MC	Defining and calculating costs
Calculate TC, TFC, TVC, AC (ATC), AFC, AVC and MC	Defining and calculating costs
Explain, with diagrams, the relationship between costs and output	Cost curves and output

The link between short run and long run average cost, and economies of scale, are separate statements and are not taught here.

Short run and long run

The short run is the period in which the firm has at least one input it cannot change. Output moves only through the variable inputs, such as labour hours or materials. In the long run every input can be changed, so the firm can alter its whole scale.

Neither is a fixed length of time. A market stall can change its stall size in weeks. A firm that needs a new factory may wait years. The test is whether a factor can be changed, not how many months have passed.

Costs follow the same split:

• Fixed costs do not change when output changes. They are paid even at zero output. Examples: rent on the workshop, hire of a machine, insurance.
• Variable costs change with output. Examples: materials, energy used in production, wages paid by the hour or per worker.

“Fixed” means fixed with respect to output. The rent may rise next year, but it did not rise because the firm made one more unit.

The law of diminishing returns

Total product (TP) is total output. Marginal product (MP) is the addition to total output from employing one more unit of the variable input. Average product (AP) is TP divided by the number of units of the variable factor.

Law of diminishing returns: keep some inputs fixed and keep adding a variable input. Past a certain point, each extra unit of the variable input raises output by less than the one before.

The law needs a fixed input, unchanged technology and variable units of equal quality, so it belongs to the short run. Take a small bookbinding workshop (illustrative) with fixed premises and one hired binding machine. Output per day depends on the number of workers:

Workers	Output (TP)	MP	AP
0	0
1	6	6	6.00
2	15	9	7.50
3	27	12	9.00
4	37	10	9.25
5	43	6	8.60
6	46	3	7.67

MP = change in TP. For the second worker, 15 − 6 = 9. MP rises to 12 at the third worker, because the first few workers can specialise and share jobs. From the fourth worker MP falls to 10, then 6, then 3. Diminishing returns set in at the fourth worker. Total output still rises throughout, so this is diminishing, not negative, returns. The cause is the fixed capital: more workers share the same benches and one machine, so each adds less.

AP rises while MP is above it and falls once MP is below it. The fourth worker’s MP of 10 is above the previous AP of 9.00, so AP rises to 9.25. The fifth worker’s MP of 6 is below 9.25, so AP falls to 8.60. AP therefore peaks at 4 workers.

Do not confuse this with diseconomies of scale. Diminishing returns happen when one factor is added to fixed others. Diseconomies of scale are a long-run idea about changing all factors together.

Defining and calculating costs

Measure	Meaning	Calculation
TFC	Total fixed cost	Given, or AFC × output
TVC	Total variable cost	Cost of variable factors, or AVC × output
TC	Total cost	TFC + TVC
AC / ATC	Cost per unit	TC ÷ output, or AFC + AVC
AFC	Fixed cost per unit	TFC ÷ output
AVC	Variable cost per unit	TVC ÷ output
MC	Extra cost of one more unit	Rise in TC ÷ rise in output

Worked example. The bookbinding workshop pays £120 a day in fixed costs. Each worker costs £60 a day. Materials cost £2 a notebook. Take 4 workers and output 37.

• TVC = 4 × 60 + 37 × 2 = 240 + 74 = £314.
• TC = 120 + 314 = £434.
• AC = 434 ÷ 37 = £11.73.
• AFC = 120 ÷ 37 = £3.24. AVC = 314 ÷ 37 = £8.49. Check: 3.24 + 8.49 = 11.73.
• MC from 3 to 4 workers = (434 − 354) ÷ (37 − 27) = 80 ÷ 10 = £8.00.

The full table (all values to the nearest penny):

Workers	Output	TFC	TVC	TC	MC	AFC	AVC	AC
0	0	120	0	120
1	6	120	72	192	12.00	20.00	12.00	32.00
2	15	120	150	270	8.67	8.00	10.00	18.00
3	27	120	234	354	7.00	4.44	8.67	13.11
4	37	120	314	434	8.00	3.24	8.49	11.73
5	43	120	386	506	12.00	2.79	8.98	11.77
6	46	120	452	572	22.00	2.61	9.83	12.43

Output moves in steps of more than one notebook, so each MC is the average extra cost per notebook across the step. If the data give single-unit steps, MC is just the rise in TC.

Cost curves and output

In a unit-cost diagram, plot cost per unit up the side and output along the bottom. Total-cost curves share the same output scale.

Curve	Shape	Why
TFC	Horizontal line at £120	Does not vary with output
TVC	Starts at the origin. Rises, first more slowly, then more steeply	Slope is MC, which falls then rises
TC	Same shape as TVC, shifted up	Vertical gap between TC and TVC is always TFC
AFC	Falls throughout, never touching either axis	AFC × output = TFC, so a rectangular hyperbola (spreading overhead)
AVC	U-shaped	Falls while MP is rising or high, rises under diminishing returns
AC	U-shaped, above AVC	AC = AVC + AFC
MC	Falls, reaches a minimum, then rises steeply	Mirror image of MP

The order of the turning points is:

Output rises: MC lowest, then AVC lowest, then AC lowest.

In the table, MC is lowest at 3 workers (£7.00), AVC at 4 workers (£8.49) and AC at about 37 to 43 notebooks (£11.73 to £11.77).

Why MC mirrors MP. If wages are the only variable cost, MC = wage ÷ MP. With materials added, MC = wage ÷ MP + materials per unit. Check the fourth worker: 60 ÷ 10 + 2 = £8.00, as in the table. When MP is high, MC is low. Once diminishing returns cut MP, MC rises. So diminishing returns explain the upward-sloping part of MC and of AVC.

The average and marginal rule. MC pulls the average towards itself:

• From 27 to 37 notebooks, MC is £8.00, below the AC of £13.11, so AC falls (to £11.73).
• From 37 to 43 notebooks, MC is £12.00, above the AC of £11.73, so AC rises (to £11.77).
• So MC cuts AC at the lowest point of AC. The same rule makes MC cut AVC at the lowest point of AVC.

Why AC has its minimum to the right of AVC. After AVC starts to rise, AFC is still falling. For a while the fall in AFC outweighs the rise in AVC, so AC keeps falling. The gap AC − AVC equals AFC, so it narrows as output grows but never closes.

Evaluating the significance of diminishing returns

Evaluation means weighing how much it matters, not only listing effects.

For the firm

• It makes MC and AVC rise at higher output. Unit costs rise as the firm squeezes more from fixed capacity, so expanding output in the short run is costly.
• It marks the limit of short-run expansion. The firm may choose to add capacity, which is a long-run decision.
• A manager can compare the extra cost of one more worker with the extra output and revenue. A worker whose MP is falling may cost more than the sales he or she brings in.
• It helps explain why supply is harder to increase quickly: at higher output, producers need a higher price to cover rising MC.

For others

• Workers: overtime or crowding may be less productive.
• Governments: a hospital or school with fixed buildings gets less extra output from each extra member of staff.
• Whole economies: farming on a fixed area of land gets a falling extra yield from extra labour.

Judgements

• It depends on timescale. If the firm can quickly add machines, the short run is short and the law bites for less time.
• It depends on flexibility. Outsourcing, shift work or hiring equipment can ease the constraint.
• It depends on demand. A firm far below capacity may be in the increasing-returns stage and never meet diminishing returns.
• Technology, training or better organisation can raise MP and delay the point at which returns diminish.

A balanced conclusion: the law is highly significant for firms with large fixed capacity and slow expansion, such as a bookbinding workshop with one building, and much less significant for firms that can rent extra capacity at short notice.

Common errors

• Claiming that total output falls. Diminishing returns describe a fall in extra output only.
• Using it for a long-run change in all factors.
• Treating AC as the sum of MC values, or MC as TC divided by output.
• Drawing MC crossing AC at any point. It crosses at AC’s lowest point.
• Forgetting that AFC falls forever and that the gap between AC and AVC is AFC.
• Writing that fixed costs are zero in the short run.
• Describing the effect without stating which cost curve moves.

Next steps

Work through the revision notes for recall and then the practice questions. Use the free 10-minute diagnostics to find gaps.

Official syllabus

OCR, A Level in Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. Component 1 content, Competition and market power area of study: the short-run cost statements under the market structures topic.