Decreasing returns

Decreasing returns, often referred to as the law of diminishing returns, is a fundamental principle within Microeconomics that describes a point at which the addition of a further unit of input, while all other inputs are held constant, results in a smaller increase in output. This phenomenon highlights a common constraint in production processes, where efficiency gains from additional inputs eventually wane. Understanding decreasing returns is crucial for businesses, economists, and policymakers as it directly impacts decisions related to resource allocation, production planning, and investment.

What Is Decreasing Returns?

Decreasing returns occur when increasing one factor of production function by one unit, while keeping all other production factors constant, yields a smaller increase in total output than previous increases. Essentially, beyond a certain point, adding more of a single input, such as labor or capital, to a fixed set of other inputs will lead to progressively smaller increments in the total product. This concept is central to understanding a firm's short-run production decisions and highlights the limits to growth when resources are not balanced. Decreasing returns are distinct from negative returns, where adding more input would cause total output to fall.

History and Origin

The concept of decreasing returns has roots in classical economics, particularly concerning agricultural production. Early economists like Turgot, Thomas Malthus, and David Ricardo observed and articulated this principle in the late 18th and early 19th centuries. They noted that as more labor and capital were applied to a fixed amount of land, the additional output from each successive unit of input would eventually decline. For instance, Thomas Malthus, in his "Essay on the Principle of Population," implicitly recognized diminishing returns by suggesting that food supply could not keep pace with population growth due to the finite nature of land and its decreasing productivity with increased cultivation⁶. While early applications focused on farming, the law of diminishing returns, or decreasing returns, is now broadly applied across various industries to explain productivity limits in manufacturing and services.

Key Takeaways

Decreasing returns refer to the point where adding more of one input, while others are fixed, yields smaller increases in output.
It is a short-run concept, assuming at least one factor of production is fixed.
The principle is crucial for understanding production efficiency, cost-benefit analysis, and optimal input levels.
Technological advancements can mitigate or delay the onset of decreasing returns but do not eliminate the principle itself.
Recognizing decreasing returns helps businesses make informed decisions about scaling operations and capital expenditures.

Formula and Calculation

Decreasing returns are not represented by a single formula but rather observed through the behavior of the marginal product of an input. Marginal product is the additional output produced by adding one more unit of a variable input, assuming all other inputs are held constant. When decreasing returns set in, the marginal product begins to fall.

The formula for Marginal Product of Labor (MPL) is:

$MPL = \frac{\Delta Q}{\Delta L}$

Where:

(\Delta Q) = Change in total output
(\Delta L) = Change in labor input

For example, if a factory increases its labor from 10 to 11 workers and output increases by 50 units, the MPL is 50. If increasing labor from 11 to 12 workers only increases output by 40 units, the MPL has decreased, indicating the onset of decreasing returns. The objective is often to reach optimal output before significant decreasing returns make additional inputs uneconomical.

Interpreting the Decreasing Returns

Interpreting decreasing returns involves recognizing that simply adding more of a single input, such as more workers to a small office or more machines to a cramped factory floor, will eventually lead to inefficiencies rather than proportional gains. It signifies that the productive capacity of the fixed inputs (e.g., land, existing machinery, factory size) is being stretched. For example, if a software development team keeps adding developers without increasing the number of project managers or adequate computing infrastructure, communication overheads might rise, and individual labor productivity could decline. This implies that businesses must seek a balanced increase in all inputs to achieve sustained growth, rather than over-investing in just one. Effective investment analysis accounts for these diminishing marginal returns.

Hypothetical Example

Consider a small T-shirt printing business that operates with a fixed number of printing machines (capital) and a limited workspace.

1 Worker: Prints 20 T-shirts per hour. (Marginal Product = 20)
2 Workers: Print 45 T-shirts per hour. (Marginal Product = 25; each worker can specialize a bit).
3 Workers: Print 65 T-shirts per hour. (Marginal Product = 20; still efficient, but less room for specialization gains).
4 Workers: Print 80 T-shirts per hour. (Marginal Product = 15; now workers might be getting in each other's way or waiting for machines).
5 Workers: Print 90 T-shirts per hour. (Marginal Product = 10; severe crowding, reduced efficiency due to limited space and machines).

In this example, decreasing returns set in after the 2nd worker, as the marginal product of each additional worker begins to decline (25 -> 20 -> 15 -> 10). The total output is still increasing, but at a diminishing rate. To increase output more efficiently beyond this point, the business would need to invest in more printing machines or a larger workspace, altering its fixed costs and variable costs.

Practical Applications

The principle of decreasing returns has numerous practical applications across various sectors:

Agriculture: Adding more fertilizer or labor to a fixed plot of land eventually yields less additional crop per unit of input due to soil saturation or crowding. This was one of the earliest contexts where the law was observed.
Manufacturing: In a factory with a fixed number of machines, adding too many workers can lead to congestion, idle time waiting for equipment, and supervisory challenges, resulting in lower increases in output per additional worker. For example, U.S. manufacturing multifactor productivity declined from 2004 through 2016 by an average of 0.3 percent per year, following a period of strong growth⁵. This suggests that factors contributing to productivity growth, such as technological advancements and efficient use of inputs, experienced some form of diminishing returns or slowdown in certain periods.
Project Management: Beyond a certain point, adding more people to a software project team (e.g., "Brooks's Law") can slow it down due to increased communication overhead and integration issues within the supply chain of tasks.
Investment and Capital Allocation: Companies face decreasing returns when additional capital investment in a particular area yields progressively smaller increases in revenue or profit. For instance, in the energy transition, continued investment in certain renewable energy projects might eventually face diminishing returns as the easiest and most efficient sites are utilized first, or infrastructure costs escalate⁴.

Limitations and Criticisms

While decreasing returns is a widely accepted economic principle, it has limitations and criticisms. One significant critique is that it primarily applies to the short run, where at least one factor of production is fixed. In the long run, all factors of production can be varied, allowing for the potential to achieve economies of scale rather than decreasing returns. Technological progress also consistently challenges the onset of decreasing returns. New inventions, process improvements, or innovative resource allocation can increase productivity for given inputs, effectively pushing out the point at which decreasing returns become evident³. For example, advancements in automation or data analytics can significantly improve manufacturing efficiency, allowing for more output with the same or even fewer human labor inputs, thus delaying or even reversing the short-term impact of diminishing returns². However, even technological progress can eventually face its own form of diminishing returns, where additional research and development efforts yield smaller breakthroughs over time¹.

Decreasing returns vs. Diseconomies of Scale

Decreasing returns and diseconomies of scale are related but distinct concepts. Decreasing returns is a short-run phenomenon where adding more of one variable input to a fixed input leads to smaller marginal increases in output. It focuses on the productivity of a single input. For example, adding more workers to a factory without expanding the factory itself.

In contrast, diseconomies of scale are a long-run phenomenon where increasing all inputs proportionally leads to a less than proportional increase in output, resulting in higher average costs of production. This typically happens when a firm grows so large that it experiences inefficiencies like complex bureaucracy, communication breakdowns, or difficulties in coordination. While both describe a decline in efficiency or productivity, decreasing returns highlights the imbalance of inputs in the short term, whereas diseconomies of scale point to the challenges of managing very large-scale operations in the long term, impacting overall returns to scale.

FAQs

What causes decreasing returns?

Decreasing returns are primarily caused by the presence of a fixed factor of production. When you keep adding a variable input (like labor) to a fixed input (like land or machinery), the variable input eventually becomes less productive because there isn't enough of the fixed input to work with efficiently. This can lead to congestion, overuse of equipment, or difficulties in coordination.

Is decreasing returns the same as negative returns?

No, decreasing returns is not the same as negative returns. Decreasing returns mean that additional units of input still increase total output, but at a slower rate than before. Total output is still rising. Negative returns, however, mean that adding more input actually causes total output to fall. This implies severe inefficiency or mismanagement, where additional inputs actively hinder production.

How can a business avoid decreasing returns?

A business can avoid or delay decreasing returns by ensuring that all factors of production are increased proportionally, particularly in the long run. In the short run, where some factors are fixed, a business should identify the point where decreasing returns set in and avoid adding more variable input beyond what is efficient. This might involve investing in more fixed capital, optimizing processes, or improving labor productivity through training or technology.