Law of diminishing marginal returns: definition, example, use in economics

What Is Law of Diminishing Marginal Returns?

The Law of Diminishing Marginal Returns is a fundamental principle within Microeconomics that states that adding an additional factor of production will, at some point, result in progressively smaller increases in output. This means that if one input in a production function is increased while all other factors of production are held constant, the marginal output from each additional unit of that input will eventually decrease. It highlights a critical concept for understanding efficiency and resource limits in economic activity⁵⁵, ⁵⁶. The principle is also known as the law of diminishing returns or the law of variable proportions.

History and Origin

The concept of diminishing returns has roots in the work of early economists, particularly in the 18th century. Jacques Turgot, a French economist, is often credited with first articulating this idea, noting that "each increase [in an input] would be less and less productive"⁵³, ⁵⁴. His insights were particularly relevant to agriculture, observing that successive applications of capital and labor to a given plot of land would eventually yield decreasing proportional increases in output⁵².

Later, in the early 19th century, classical economists such as Thomas Robert Malthus and David Ricardo further developed and popularized the law of diminishing returns⁵¹. Malthus applied a variation of the law to his population theory, suggesting that food production could not keep pace with geometric population growth due to diminishing returns on land⁴⁸, ⁴⁹, ⁵⁰. Ricardo, along with others, applied the concept to land rent, observing that higher grain prices during the Napoleonic Wars led to the cultivation of less fertile land, where additional inputs yielded lower returns⁴⁶, ⁴⁷. This historical development underscores its importance in understanding core economic challenges related to scarcity and production limits. The law now lies at the heart of many branches of economics, including theories of production, investment, and economic growth. Optimal decision making and matching are tied through diminishing returns⁴⁵.

Key Takeaways

• The Law of Diminishing Marginal Returns posits that increasing one input in production while keeping others fixed will eventually lead to smaller incremental increases in output.
• It is a short-run concept, implying that at least one factor of production is held constant.⁴³, ⁴⁴
• The law does not mean total output will decrease, but rather that the rate of increase in output will slow down after a certain point.
• Understanding this principle helps businesses and policymakers optimize resource allocation and production processes.⁴¹, ⁴²
• Technological advancements and process improvements can mitigate or postpone the effects of diminishing returns.⁴⁰

Formula and Calculation

The Law of Diminishing Marginal Returns is observed through the calculation of marginal product. Marginal product refers to the additional output generated by adding one more unit of a variable input while holding all other inputs constant.

Mathematically, the marginal product of labor (MPL) can be expressed as:

Where:

• (MP_L) = Marginal Product of Labor
• (\Delta TP) = Change in Total Product (output)
• (\Delta L) = Change in Labor (input)

When the (MP_L) begins to decline, the law of diminishing marginal returns has set in³⁹. This means that each additional unit of labor contributes less to the total output than the previous unit. Firms aim to operate where marginal product is positive but before it declines significantly, to manage marginal cost and maximize efficiency.

Interpreting the Law of Diminishing Marginal Returns

Interpreting the law of diminishing marginal returns involves recognizing the point at which additional variable inputs begin to yield less proportional increases in output. This point is crucial for businesses to determine their optimal level of operation in the short run³⁷, ³⁸.

For instance, in a factory with a fixed number of machines, adding more workers might initially increase output significantly. However, beyond a certain number of workers, they might start getting in each other's way, leading to less efficient use of the machines and a smaller increase in total output with each new worker. The goal is to identify this "optimal level" where inputs are most effectively utilized before the returns from additional inputs begin to diminish³⁵, ³⁶. By understanding this, firms can make informed decisions about resource allocation to maximize efficiency and avoid over-investment in a single factor of production³⁴. The law essentially illustrates that sustained increases in output from continuously adding just one input are not infinitely possible³³.

Hypothetical Example

Consider a small artisanal bakery with a fixed oven and mixing equipment. The owner, initially working alone, can produce 20 loaves of bread per day.

1. Adding a second baker: With two bakers, they can divide tasks (one mixes, one bakes), leading to increased specialization. Daily output jumps to 50 loaves. The marginal product of the second baker is 30 loaves.
2. Adding a third baker: A third baker further helps, perhaps with packaging and customer service, increasing daily output to 75 loaves. The marginal product of the third baker is 25 loaves. While output increased, the additional output from the third baker (25) is less than the additional output from the second baker (30). The law of diminishing marginal returns is starting to manifest.
3. Adding a fourth baker: A fourth baker is hired. Now, the bakery's space becomes crowded, and there's only one oven. Bakers might have to wait to use the mixer or the oven. Daily output increases to 90 loaves. The marginal product of the fourth baker is 15 loaves. This clearly shows diminishing marginal returns, as the fixed capital (oven, space) acts as a constraint, limiting the effectiveness of additional labor. The fixed costs associated with the oven remain, while the benefit of each additional worker declines.
4. Adding a fifth baker: Adding a fifth baker might lead to even more congestion and communication issues, increasing daily output only to 95 loaves. The marginal product of the fifth baker is just 5 loaves. Beyond this point, further additions of labor without increasing capital expenditure on ovens or space would yield even smaller, or even negative, returns.

Practical Applications

The Law of Diminishing Marginal Returns has wide-ranging practical applications across various economic sectors and decision-making processes:

• Agriculture: This is the classic application. Farmers increase fertilizer or labor on a fixed plot of land. Initially, yields increase, but beyond a certain point, adding more inputs results in smaller gains in crop yield, or even damage to the land²⁹, ³⁰, ³¹, ³².
• Manufacturing: In a factory, adding more workers to a production line with a fixed number of machines can initially boost output. However, eventually, workers may start getting in each other's way, or there might not be enough equipment to keep everyone productive, leading to diminishing returns on labor²⁵, ²⁶, ²⁷, ²⁸.
• Technology and Innovation: While technology can mitigate diminishing returns, its development and adoption can also be subject to it. Initial investments in new technologies like artificial intelligence (AI) may yield significant productivity gains, but as the technology matures or becomes widespread, the incremental benefits for new adopters may decrease²³, ²⁴. Companies investing in innovation must consider the cost-benefit analysis of each additional investment²².
• Human Resources and Management: Hiring additional employees without a proportional increase in other resources (e.g., office space, management support, tools) can lead to a decline in per-employee productivity. This informs staffing levels and organizational design²¹.
• Government Policy: Policymakers consider the law when allocating public funds. For instance, investing more in a specific infrastructure project may initially provide large benefits, but continuously pouring money into the same project without addressing other constraints might lead to diminishing returns on public investment. Understanding how factors like labor productivity contribute to overall economic health is a key consideration. Labor Productivity and the Financial Cycle.

Limitations and Criticisms

While the Law of Diminishing Marginal Returns is a cornerstone of economic theory, it has certain limitations and is subject to critiques, primarily concerning its applicability in dynamic environments.

One major point is that the law strictly applies when only one input is varied while all others are held constant²⁰. In the real world, businesses often adjust multiple inputs simultaneously. For example, a factory might hire more workers and invest in new machinery at the same time, potentially offsetting the diminishing returns that would occur if only workers were added¹⁹.

Technological advancements and innovation are key factors that can significantly postpone or mitigate the effects of the law of diminishing marginal returns¹⁷, ¹⁸. New production methods, automation, and improved efficiency can increase the productivity of existing inputs or reduce the need for certain inputs, allowing output to grow without encountering the same diminishing returns¹⁵, ¹⁶. For instance, modern agriculture, through scientific advancements in seeds, fertilizers, and machinery, has vastly increased yields on fixed land, defying the dire predictions of early economists like Malthus in many parts of the world¹³, ¹⁴.

Furthermore, the law is primarily a short-run concept. In the long run, firms have the flexibility to adjust all factors of production, including fixed assets like factory size or land. This ability to reconfigure production processes means that, over time, companies can overcome the constraints that lead to diminishing returns in the short term, though new constraints may eventually emerge¹¹, ¹². Businesses strive to implement strategies To Counteract Diminishing Returns¹⁰.

Law of Diminishing Marginal Returns vs. Returns to Scale

The Law of Diminishing Marginal Returns and Returns to Scale are distinct but related concepts in production theory, often confused due to their focus on input-output relationships.

The Law of Diminishing Marginal Returns refers to a situation where, in the short run, increasing only one variable input (e.g., labor) while keeping at least one other input (e.g., capital) fixed eventually leads to smaller and smaller increases in output⁸, ⁹. In contrast, returns to scale describe what happens to total output when all inputs are increased proportionally in the long run. There can be increasing, constant, or decreasing returns to scale. For example, a company might experience increasing returns to scale if doubling all inputs more than doubles output, often due to efficiencies of larger operations or specialization.

FAQs

What causes the Law of Diminishing Marginal Returns?

The law occurs because, in the short run, at least one factor of production (like machinery or land) is fixed. As more and more of a variable input (like labor) is added to this fixed input, the variable input eventually has less and less of the fixed input to work with, leading to congestion, inefficiency, and smaller incremental output gains⁶, ⁷.

Does diminishing marginal returns mean total output decreases?

No, the Law of Diminishing Marginal Returns does not imply that total output will decrease. Instead, it means that the rate at which total output increases will slow down. Each additional unit of input contributes less to the total output than the previous unit, but output still increases, just at a decreasing rate. Eventually, it can lead to negative returns where total output declines, but that's a more extreme stage⁵.

How do businesses deal with diminishing marginal returns?

Businesses deal with the law of diminishing marginal returns by optimizing their resource allocation and production processes. This often involves identifying the optimal point where additional inputs are most effective, and then considering investments in new technologies, improving employee skills through training, or expanding their fixed assets (like buying more machinery or bigger facilities) to shift their production function and avoid the diminishing returns threshold³, ⁴. This helps them maintain or increase productivity and profitability.

Is the law of diminishing returns always true?

The Law of Diminishing Marginal Returns is a widely accepted economic principle that holds true under its specific conditions: when at least one input is fixed and technology remains constant. However, in dynamic real-world scenarios, technological advancements, process innovations, and the ability to adjust all inputs in the long run can mitigate or postpone its effects¹, ². The principle is a foundational concept for understanding the limits of production in the short term.