The principle of increasing opportunity costs states that

By Indeed Editorial Team

Published May 11, 2021

Often, suppliers choose to increase their production of goods in order to increase profits, but increasing production can also increase costs. The law of increasing cost explains why costs can increase as production increases. If you own a business or work in the field of economics, then understanding the law of increasing cost can help you make informed decisions for your company and use your company's production resources efficiently. In this article, we explain what the law of increasing cost is and who uses it, and we also list examples and frequently asked questions related to this concept.

What is the law of increasing cost?

The law of increasing cost is an economic principle that states that when a supplier increases the production of a good, the opportunity cost of producing additional goods also increases. Opportunity cost refers to the opportunities and benefits that suppliers lose when they choose one option over another and dedicate their resources to that option. In other words, opportunity cost subtracts the cost of the chosen outcome from the cost of the outcome that a company could have chosen. As the opportunity cost of producing a product increases, the process of producing goods also becomes less efficient.

Often, suppliers want to increase the production of a good in an effort to increase their profits, but the law of increasing cost essentially means that when factors of production are maximized, costs also increase. The main factors of production include land, labor and capital. Sometimes, suppliers can avoid the effects of the law of increasing cost by changing aspects of their production methods.

You can visualize the law of increasing cost on an economic model called a production possibility frontier (PPF). A PPF is a graph that can illustrate a company's possible output combinations for producing two goods that use the same set of resources. A PPF is useful because it can allow you to analyze the curve of the graph locate the point of highest production efficiency and, as a result, make decisions that have the best possible results for your company.

Related: Understanding Economics: Definition and Application

Who uses the law of increasing cost?

People who use the law of increasing cost often work in the field of economics, including economists, financial analysts, accountants and other economic professionals. Business owners can also benefit from understanding the law of increasing cost, as it can often help them operate their businesses at their full capacity and as efficiently as possible. This can help business owners to maximize their profits, which can heavily contribute to the success of a company. Therefore, the law of increasing cost can be extremely useful for business owners to understand to maintain the financial health of their company.

Related: 18 Top Economics Degree Jobs

Law of increasing cost example

An example of the law of increasing cost is increasing your small technology accessory business's production of laptop cases. Your business typically sells laptop cases for $50 and phone cases for $40. Because you want to increase laptop case production, you decide to move some of your employees from your business's phone case department to the laptop case department to help make more laptop cases.

However, because the phone case department employees are more experienced with making phone cases than laptop cases, it ends up taking them twice as long to make a laptop case as the laptop case department employees. Therefore, when one of the phone case employees makes a laptop case, you lose $80, the amount you would make from selling two phone cases, to make $50 from selling one laptop case.

Related: Production Process: Definition and Types for Businesses To Use

Law of increasing cost FAQ

Here are some frequently asked questions related to the law of increasing cost:

Why is the law of increasing cost important?

Understanding the law of increasing cost is important because it can help you run your business efficiently and reach the largest possible profit. Additionally, understanding the law of increasing cost can help you to avoid losing opportunity costs when you produce products as well as to make informed production decisions for your business overall. Additionally, the law of increasing opportunity cost can help you decide how to allocate your production resources, making it valuable knowledge for people who work in resource management.

Read more: How Opportunity Cost Can Help You Make Better Decisions (with Examples)

When should you use the law of increasing cost?

The law of increasing cost is useful to consider before your business increases the production of a certain product. To understand the law of increasing cost as it relates to your business, it can be helpful to look at your situation on a production possibility frontier. Using a production possibility frontier can help you visualize the possible output combinations if your business attempts to produce two goods that use the same set of resources. This can help you make production decisions that have the best results for your business.

Does the law of increasing cost cause profits to decrease?

The law of increasing cost can sometimes mean that profit margins decrease due to higher production costs. However, aside from profit, opportunity costs can also include time, labor and other factors. Therefore, according to the law of increasing cost, profit margins can often decrease when production increases, but there are also other opportunity costs that can decrease instead.

Related: What Is Profit and Why Is It Important?

Does the law of increasing cost apply to every situation?

The law of increasing cost does not always apply to production situations. In some cases, suppliers can avoid or delay the effects of the law of increasing cost by altering the production methods that they use. For example, a supplier could choose an alternative, less expensive material for a product to offset the increased cost of production.

We see in Figure 2.4 "The Combined Production Possibilities Curve for Alpine Sports" that, beginning at point A and producing only skis, Alpine Sports experiences higher and higher opportunity costs as it produces more snowboards. The fact that the opportunity cost of additional snowboards increases as the firm produces more of them is a reflection of an important economic law. The law of increasing opportunity cost holds that as an economy moves along its production possibilities curve in the direction of producing more of a particular good, the opportunity cost of additional units of that good will increase.

We have seen the law of increasing opportunity cost at work traveling from point A toward point D on the production possibilities curve in Figure 2.4 "The Combined Production Possibilities Curve for Alpine Sports". The opportunity cost of each of the first 100 snowboards equals half a pair of skis; each of the next 100 snowboards has an opportunity cost of 1 pair of skis, and each of the last 100 snowboards has an opportunity cost of 2 pairs of skis. The law also applies as the firm shifts from snowboards to skis. Suppose it begins at point D, producing 300 snowboards per month and no skis. It can shift to ski production at a relatively low cost at first. The opportunity cost of the first 200 pairs of skis is just 100 snowboards at Plant 1, a movement from point D to point C, or 0.5 snowboards per pair of skis. We would say that Plant 1 has a comparative advantage in ski production. The next 100 pairs of skis would be produced at Plant 2, where snowboard production would fall by 100 snowboards per month. The opportunity cost of skis at Plant 2 is 1 snowboard per pair of skis. Plant 3 would be the last plant converted to ski production. There, 50 pairs of skis could be produced per month at a cost of 100 snowboards, or an opportunity cost of 2 snowboards per pair of skis.

The bowed-out shape of the production possibilities curve illustrates the law of increasing opportunity cost. Its downwards slope reflects scarcity.

Figure 2.5 "Production Possibilities for the Economy" illustrates a much smoother production possibilities curve. This production possibilities curve in Panel (a) includes 10 linear segments and is almost a smooth curve. As we include more and more production units, the curve will become smoother and smoother. In an actual economy, with a tremendous number of firms and workers, it is easy to see that the production possibilities curve will be smooth. We will generally draw production possibilities curves for the economy as smooth, bowed-out curves, like the one in Panel (b). This production possibilities curve shows an economy that produces only skis and snowboards. Notice the curve still has a bowed-out shape; it still has a negative slope. Notice also that this curve has no numbers. Economists often use models such as the production possibilities model with graphs that show the general shapes of curves but that do not include specific numbers.

Figure 2.5 Production Possibilities for the Economy

As we combine the production possibilities curves for more and more units, the curve becomes smoother. It retains its negative slope and bowed-out shape. In Panel (a) we have a combined production possibilities curve for Alpine Sports, assuming that it now has 10 plants producing skis and snowboards. Even though each of the plants has a linear curve, combining them according to comparative advantage, as we did with 3 plants in Figure 2.4 "The Combined Production Possibilities Curve for Alpine Sports", produces what appears to be a smooth, nonlinear curve, even though it is made up of linear segments. In drawing production possibilities curves for the economy, we shall generally assume they are smooth and "bowed out," as in Panel (b). This curve depicts an entire economy that produces only skis and snowboards.

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