Law of diminishing returns: Meaning, Criticisms & Real-World Uses

What Is the Law of Diminishing Returns?

The law of diminishing returns is a fundamental principle in Production Theory asserting that if one factor of inputs in a production process is continuously increased while all other capital inputs are held constant, the marginal gain in output will eventually decrease. This means that beyond a certain point, adding more of a single input, such as labor, will lead to smaller and smaller increases in total production. The law of diminishing returns does not imply that total output will necessarily fall, but rather that the rate of increase in output will slow down, impacting overall efficiency.

History and Origin

The concept of diminishing returns has roots in the 18th century, with early economists observing its effects primarily in agriculture. Anne-Robert-Jacques Turgot, a French economist, is often credited with first articulating the principle, noting that successive additions of inputs to land would yield progressively less productive results.⁶ However, it was David Ricardo, a prominent British classical economist, who further developed and popularized the law of diminishing returns in his 1817 work, "The Principles of Political Economy and Taxation."⁵ Ricardo observed that as farmers added more and more labor to a fixed amount of land, the additional output generated by each new unit of labor would eventually decline.⁴ This observation was crucial to understanding agricultural productivity and its limits.

Key Takeaways

The law of diminishing returns states that increasing one input while holding others constant will eventually lead to smaller increases in output.
It is a core concept in microeconomics, particularly in Production Theory.
The law implies that there is an optimal level of input for maximum productivity before efficiency begins to decline.
It does not mean total output will decrease, but rather that the rate of increase slows, leading to a lower marginal product.

Formula and Calculation

The law of diminishing returns does not have a single, universal formula, as it describes a behavioral pattern rather than a precise mathematical relationship applicable across all scenarios. However, it can be understood by examining the relationship between total product and marginal product.

Total Product ( $TP$ ): The total quantity of output produced by a given amount of inputs.
Marginal Product ( $MP$ ): The additional output produced by adding one more unit of a variable input, holding all other inputs constant.

The marginal product can be calculated as:

$MP = \frac{\Delta TP}{\Delta Variable\ Input}$

Where:

$\Delta TP$ represents the change in total product.
$\Delta Variable\ Input$ represents the change in the variable input.

The law of diminishing returns states that at some point, as the variable input increases, the $MP$ will start to decrease.

Interpreting the Law of Diminishing Returns

Interpreting the law of diminishing returns involves recognizing the point at which adding more of a variable input, such as labor or raw materials, no longer yields proportionally increasing returns. Initially, adding more of a variable input can lead to increasing marginal returns, as it allows for specialization and more efficient use of fixed costs and fixed inputs. However, beyond a certain threshold, the fixed factors become saturated or overutilized. For example, if a factory has a fixed number of machines, adding too many workers will eventually lead to congestion, idle time for some workers, or a breakdown in coordination, causing the additional output from each new worker to diminish.³ Understanding this point is crucial for effective resource allocation and operational planning, ensuring resources are not over-applied inefficiently.

Hypothetical Example

Consider a small bakery that has a fixed amount of space, ovens, and mixers. The variable input is the number of bakers.

1 Baker: Can produce 100 loaves of bread per day. (Marginal Product = 100)
2 Bakers: Can produce 250 loaves per day. The second baker allows for specialization (one mixes, one bakes). (Marginal Product = 150)
3 Bakers: Can produce 370 loaves per day. (Marginal Product = 120) The third baker adds less than the second, but total output is still rising.
4 Bakers: Can produce 450 loaves per day. (Marginal Product = 80) Here, the law of diminishing returns is evident. While total production continues to rise, the additional output contributed by the fourth baker is less than that of the third, second, or even first. They might start getting in each other's way due to limited oven space or a single mixing station, impacting overall productivity.
5 Bakers: Can produce 480 loaves per day. (Marginal Product = 30) The fifth baker adds very little, indicating severe diminishing returns as resources like oven space become highly constrained, leading to significant inefficiencies.

In this scenario, the bakery would need to consider expanding its capital (ovens, mixers, space) to hire more bakers productively and overcome the limitations imposed by the law of diminishing returns.

Practical Applications

The law of diminishing returns has widespread applications across various economic and business contexts:

Agriculture: As historically observed, adding more fertilizer or labor to a fixed plot of land eventually yields smaller increases in crop output. This principle is a key consideration in global efforts to sustainably increase agricultural output and food security.²
Manufacturing: In a factory with a fixed number of machines, hiring too many workers can lead to congestion and idle time, causing the marginal product of each additional worker to decline. Businesses must manage their variable costs in relation to fixed assets to maximize efficiency.
Software Development: Adding more developers to a project beyond a certain point might not accelerate completion proportionally, due to increased communication overhead, coordination challenges, and the inherent indivisibility of certain tasks.
Investment and Capital Expenditure: Corporations evaluating new projects or expanding existing ones must consider the point at which further investment might yield progressively lower returns. This is particularly true for infrastructure investments where initial returns are high but subsequent additions face decreasing benefits due to factors like existing network density or limited available land.
Public Policy: Governments face diminishing returns in areas like public health spending or education. Beyond a certain level, additional funding may yield smaller improvements in outcomes due to underlying systemic issues or the challenge of reaching increasingly difficult-to-impact populations.

Limitations and Criticisms

While the law of diminishing returns is a foundational economic principle, it operates under specific assumptions and has limitations:

Assumptions of Fixed Inputs: The law strictly applies when at least one factor of production remains fixed. In the long run, businesses can often adjust all inputs, including capital and land, which can shift the point at which diminishing returns occur or even lead to increasing returns to scale.
Technological Advancement: Technological innovation can significantly alter or delay the onset of diminishing returns. New technologies can make existing inputs more productive, effectively increasing the "fixed" capacity or creating new production methods that defy previous limitations. For example, advancements in agricultural science have continually pushed back the point of diminishing returns in farming.
Homogeneity of Inputs: The law assumes that additional units of the variable input are homogeneous (e.g., all workers are equally skilled). In reality, firms might hire less productive workers as they expand, which could contribute to declining productivity independently of the law itself.
Short-Run Phenomenon: The law is primarily a short-run concept. In the long run, all factors of production are variable, allowing firms to change their scale of operations to potentially avoid or mitigate diminishing returns.

Understanding these limitations is vital for a comprehensive view, recognizing that while the law holds true under its stated conditions, its applicability can be influenced by dynamic factors like innovation and flexible resource allocation.

Law of Diminishing Returns vs. Diminishing Marginal Utility

While both concepts involve the idea of "diminishing," the law of diminishing returns and diminishing marginal utility apply to different aspects of economics. The law of diminishing returns is a concept in Production Theory, focusing on the relationship between increasing productive inputs and the resulting output in production. It states that beyond a certain point, adding more of a variable input to a fixed input will yield smaller increases in total production. In contrast, diminishing marginal utility is a concept in consumer theory, which posits that as a consumer consumes more and more units of a good or service, the additional satisfaction or utility derived from each subsequent unit decreases. For example, the first slice of pizza might bring immense satisfaction, but the tenth slice will likely bring very little, if any, additional enjoyment. The former deals with how goods are made, while the latter deals with how goods are consumed and valued.

FAQs

What causes the law of diminishing returns?

The law of diminishing returns occurs because, in the short run, at least one factor of inputs is fixed. As more of the variable input (like labor) is added to this fixed input (like capital or land), the fixed input becomes increasingly congested or over-utilized, leading to less efficient use of the additional variable input. This leads to a decrease in marginal productivity per unit of variable input.¹

Does the law of diminishing returns mean production will decrease?

No, the law of diminishing returns does not necessarily mean that total production will decrease. It means that the rate of increase in output will slow down. Each additional unit of input will contribute less to the total product than the previous unit, but total output can still be increasing, just at a slower pace. Eventually, if too much of the variable input is added, total output could indeed start to decline, but this is referred to as "negative returns," which occurs after the point of diminishing returns.

Is the law of diminishing returns always true?

The law of diminishing returns holds true under its specific assumptions, particularly that at least one input is fixed and the technology used remains constant. In the real world, businesses can innovate, improve processes, or invest in more capital over the long term, which can shift the point at which diminishing returns occur or even lead to increasing returns to scale. However, for any given production process with fixed factors, the principle will eventually apply due to the fundamental concept of scarcity and limited resources.