Law of Diminishing Marginal Returns: Definition, Explanation and Examples
If you were a farmer, how would you determine the optimum number of farmhands to employ, or the amount of fertilizer to use on your crop?
If you owned a pizza outlet, how would you determine the optimum number needed at your pizza joint?
In all these situations, the optimum number of chefs and farmhands and amount of fertilizer needed depends on something known as the law of diminishing marginal returns.
The law of diminishing marginal returns is a universal economic law that states that, in any production process, if you progressively increase one input, while holding all other factors/inputs constant, you will eventually get to a point where any additional input will have a progressive decrease in output.
In other words, you will get to a point where the benefits gained from increasing each extra unit of the input will start decreasing.
For instance, holding other factors constant, increasing the number of chefs in your pizza outlet will increase pizza production up to a certain point.
However, it will get to a point where increasing the number of chefs will not result in any meaningful increase in pizza production. If you keep increasing the number of chefs, it can even result in a decrease in pizza production.
The law of diminishing marginal returns is a scientific expression of the common knowledge that too much of a good thing can actually be harmful to you.
It is good to note that the law of diminishing marginal returns is only applicable on a short term basis, because some other factor of production will eventually change in the long run.
The law of diminishing marginal returns traces its roots back to the world’s very earliest economists, such as David Ricardo, Thomas Robert Malthus, Johann Heinrich Von Thunen, James Steuart and Jacques Turgot.
These early economists, ignoring the possibility that the means of production would be improved by advances in science and technology, used the law of diminishing marginal returns to theorize that due to the increasing world population it would get to a point where the output per head would start decreasing.
This would plunge the world into a state of poverty that would effectively keep the global population from further growth. This was the origin of the Malthusian theory of population, which stated that the global population would one day outgrow its food supply.
While advances in science and technology have certainly improved the means of production, thereby negating the effects of the law on global population and improving the standards of living despite the growing population, the effects of the law can still be witnessed in stagnant economies where the methods of production have remained unchanged for long periods.
The law of diminishing marginal returns can also be referred to as the law of increasing costs, owing to the fact that it can also be described in terms of average cost.
When an increase in one factor of production is accompanied by diminishing marginal returns, then this leads to an increase in the average cost of production.
For instance, increasing the number of chefs in your pizza joint will be accompanied by an increase in the salary paid to your chefs cumulatively.
Once it gets to the point of diminishing marginal returns, increasing an additional chef will increase your production costs (salary paid to chefs) without a proportional increase in pizza production.
This is why the law can also be referred to as the law of increasing costs.
The law of diminishing marginal returns is usually represented in graphical form using three curves: the marginal product curve, the total product curve and the average product curve.
The marginal product curve shows the change in amount of production per input.
The total product curve shows the change in production with progressive increase in one production input.
The average product curve shows the change in average production.
CAUSES FOR THE OPERATION OF THE LAW OF DIMINISHING MARGINAL RETURNS
There are a number of factors that make the operation of the law of diminishing returns possible. These include:
Fixed Factors of Production
The law of diminishing marginal returns is made possible by the fact that certain factors of production are fixed. The four factors of production – capital, labor, land and entrepreneurship – cannot all be increased in every instance.
At the same time, all the four factors have to be effectively combined in order for production to occur.
This means that effective increase in production can be achieved by increasing all the factors of production.
However, the fact that not all factors of production can be increased in every situation create an imbalance in production.
This increase in some factors of production while others remain fixed creates the perfect situation for the application of the law of diminishing marginal returns.
In some cases, some factors of production, such as land, are limited in nature and can therefore not be increased.
In such cases, the law of diminishing marginal returns will apply.
However, this is not limited to land. Any of the other factors of production could also be scarce, depending on the situation.
In such instances, an increase in some factors of production without a corresponding increase in others will disturb the balance of the factors, making it impossible for production to be increased at increasing rates.
Lack of Perfect Substitutes
Sometimes, the law of diminishing marginal returns applies because no perfect substitute can be found to replace one of the factors of production.
If there is a decrease in one factor of production and no suitable substitute can be found then the law will definitely apply in this situation.
The optimum level of production is only achieved by a delicate balance of all the factors of production.
One this optimum level has been achieved, any further increase in any of the factors of production will lead to a less efficient balance of these factors, resulting in a negative impact on the rate of production.
In other words, increasing any single factor of production once the optimum level of production has been reached will result in the effects of the law of diminishing marginal returns.
ASSUMPTIONS OF THE LAW OF DIMINISHING MARGINAL RETURNS
For the law to be applicable in any situation, it makes the following assumptions:
No Change in Technology
The law assumes that the progressive increase in the input is not accompanied by any change in the techniques of production.
A change in the production technique will result in increased efficiency of production, thus negating the effects of the law.
Therefore, for this law to apply, the method of production has to remain unchanged.
Like I noted earlier, the law of diminishing marginal returns is only applicable in short term scenarios.
It is unlikely that all the other variables factors of production will remain unchanged over a long period of time, making the law inapplicable in long term scenarios.
The law assumes that the units of all the variable factors of production are equal.
Measurement of Product
The law assumes that the output of the production process can be measured or quantified in physical units, such as kilograms, liters or number of units.
THE RELATIONSHIP BETWEEN THE LAW OF DIMINISHING RETURNS AND THE 3 STAGES OF PRODUCTION
The first stage of production is characterized by tremendous growth.
During this stage, any increase in a variable input will lead to a corresponding increase in the rate of production, signifying increasing marginal return.
The increase in rate of production outweighs the investment on the variable input. At this stage, all the three curves are positive.
In the second stage of production, the marginal returns start decreasing. Every extra variable unit added will still increase production, but at a decreasing rate.
In other words, the benefit gained from every additional unit of input will be less than the benefit gained from the previous unit.
It is during this stage that the law of diminishing returns becomes applicable. During this stage, the total product curve is still rising. However, the marginal curve and the average product curve start taking a dip.
This is the final stage of production. During this stage, the marginal returns become negative. In other words, it becomes counterproductive to keep increasing the variable input.
Any increase in the variable input results in a decrease in the rate of production.
This happens as a result of limitations arising from inefficiency and the capacity of labor or capital.
At this stage, the total product curve starts taking a dip while the other two curves maintain their downward trend.
REAL LIFE EXAMPLES OF THE LAW OF DIMINISHING MARGINAL RETURNS
Example One: The Farmer
Let us imagine a farmer who plans to plant maize on a once acre piece of land. In addition to land, the farmer will need other inputs such as seeds, fertilizer and labor.
The farmer has already bought the amount of seeds he needs and he has farmhands to help him out at his farm.
However, the farmer is yet to decide on the amount of fertilizer he is going to use on the farm. If he increases the amount of fertilizer, he will definitely increase the amount of grain he stands to harvest from the farm.
However, if he keeps increasing the fertilizer, it will get to a point where the fertilizer will become harmful to his crop, resulting in decreased yield from the farm.
According to the law of diminishing marginal returns, the farmer will get to a point where adding an extra bag of fertilizer will result in less increase in yield compared to the previous bag.
To understand how this works, let us look at the table below.
|Bags of Fertilizer||Bags of Grain||Marginal Bags of Grain|
If the farmer uses one bag of fertilizer, he will harvest 10 bags of grain from the farm. If he uses two bags of fertilizer, he increases his total yield to 30 bags of grain.
In this case, the marginal (additional) yield gotten from the second bag of fertilizer is 20 bags. If he increases the third bag of fertilizer, the total yield will be 60 bags, while the marginal yield from the third bag of fertilizer will be 30 bags of grain.
However, after adding the fourth bag of fertilizer, the law of decreasing marginal returns kicks in.
While the fourth bag of fertilizer increases the total yield to 80 bags of grain, the marginal yield is only 20 bags which is a decrease from 30 for the previous bag of fertilizer.
After the sixth bag of fertilizer, the marginal yield of each bag will become negative, at which point the total yield will also start decreasing.
Example Two: A Small Café
Let us imagine an entrepreneur who sets up a small café and buys four stoves. The entrepreneur then hires 2 chefs to prepare the special dinners for which the café is famous.
Each of the two chefs cooks using two stoves. However, their productivity is not maximized, since the chefs cannot efficiently cook two meals simultaneously.
As more and more customers come to the café, the entrepreneur decides to hire two more chefs. At this point, more food is prepared, and more customers flock to the café.
Since there are four chefs and four stoves, each of the stoves is efficiently utilized, and all the four chefs can cook a meal simultaneously.
However, as the number of customers keeps increasing, the entrepreneur decides to hire two more chefs. At this point, the marginal utility of the chefs will decrease.
This is because there are more chefs that stoves, meaning two chefs will have to waste time waiting for a stove to be freed.
If the entrepreneur decides to hire two more chefs, there will increasing conflict for the stoves, cookware, ingredients, and so on. The chefs will also start getting in each other’s way, leading to a decrease in the total amount being prepared.
Therefore, it becomes impossible for the entrepreneur to increase food production by hiring more chefs. I
nstead, increasing the chefs starts lowering the food production rate (while increasing the cumulative salary paid to the chefs).
Example Three: Factory
Imagine a shoe factory where different parts of the shoe are made by hand by the workers, but they all have to pass through one machine where they are stitched together to produce a complete shoe.
With a low number of workers making the parts, the stitching machine will be underutilized, with some periods of idleness as it waits for more parts to be made.
If the factory increases the number of workers, more shoes will be produced, because there will be more workers making the shoe parts and the stitching machine will be utilized more efficiently.
However, if the factory keeps increasing the number of workers, it will get to a point where the workers will be making the different shoe parts at a faster rate than the machine can stitch them together.
This is where the law of diminishing returns kicks in. From there, any further increase in the number of workers will not increase production, because there will be a backlog at the stitching machine.
SIGNIFICANCE OF THE LAW OF DIMINISHING MARGINAL RETURNS
The law of diminishing marginal returns is a very significant law in economics. The law has a number of theoretical and practical applications.
Some of the theoretical applications of the law include:
- The law is used to explain the equilibrium condition and behavior of a rational consumer in regards to a single commodity and a single want.
- The law of diminishing marginal returns is a universal law that forms the basis of several other economic laws and concepts. For instance, the law of diminishing marginal returns is the basis on which the law of demand is formed. The law of demand states that consumers will purchase larger quantities of commodities at a lower price. This is because, as the consumer purchases more and more units of the commodity, each additional unit provides less and less marginal utility, and therefore it is of less importance to the consumer. As such, the consumer will only buy additional units if they are offered at a lower price.
- The paradox of value, also referred to as the diamond-water paradox, can also be explained using the law of diminishing marginal returns. The paradox of value is an economic theory that states there are two kinds of value: the value arising from the utility of an object (value-in-use) and the value arising from the purchasing power conveyed by possession of an object (value-in exchange). For instance, diamonds have a great value-in-exchange. This is because of their scarcity, which drives up their marginal utility. Water, on the other hand, is available in abundance, therefore it has very low marginal utility. The result is that diamonds are way more expensive than water, despite being more useful than diamonds. This is because the marginal utility of a commodity determines its price.
- The law of diminishing marginal utility is the foundation on which Prof. Marshall’s theory of taxation and public expenditure is based. Marshall’s theory, which advocates for equitable distribution of wealth, is more like an application of the law of diminishing marginal returns to money. According to Marshall, the utility of money derived from the rich is a lot less than the utility of the same amount of money being accrued to the poor. In other words, if you take $100 from a rich man’s income, it is only a small sacrifice with relatively little utility. However, if the $100 is added to a poor man’s income, it provides greater utility. The satisfaction gained by the poor man from the $100 is a lot more than the loss felt by the rich man for the same $100.
- The Malthusian Theory of Population, the Ricardian Theory of Rent, the theory of pricing of factors of production, as well as several other theories relating to profits, interest and wages are based on the law of diminishing returns.
Apart from these theoretical applications, the law of diminishing marginal returns also has some practical significance, such as:
- The practice of promoting sales by reducing prices is based on the law of diminishing marginal returns. When the price of a commodity decreases, the consumer has to decrease the marginal utility in order to attain equilibrium. Since marginal utility decreases with increase in stock, the consumer can purchases more units of the commodity in order to achieve equilibrium.
- The law has also been used by governments in many countries to come up with appropriate tax policies. These countries apply progressive taxation on higher income earners on the basis that high income earners will feel less impact. This is because an increase in income decreases the marginal utility of money.
- The law has also been used by socialists to promote social welfare and equitable redistribution of wealth on the basis that the redistribution will result in great gains to the poor with little sacrifice from the rich.
- The law has also been used to understand and explain the economic problems faced by developing countries. This is because the main economic activity in most of these countries is agriculture, which is where the effects of the law of diminishing returns are most visible. The law can also be used to boost agricultural productivity in these countries.
- Managers also use the law of diminishing marginal returns to determine the optimum number of employees required for maximum productivity. If an organization finds itself in Stage One of production, it means that the capital is not being utilized to the maximum, so the solution is to increase the number of employees. If the organization is in Stage Two, the manager can work out the optimum number of employees and the maximum level of productivity the organization is capable of achieving. If the organization is in Stage Three of production, then it means that the organization needs to reduce the number of employees.
HOW THE LAW OF DIMINISHING MARGINAL RETURNS APPLIES IN DAILY LIFE
While it might seem like the law of diminishing returns only applies in business, the law is applicable in our day to day lives.
Below are some areas where you might notice the effects of the law:
Work: When working on a project, the work you put in initially greatly improves the quality of the project. If you keep working on it for longer time than you needed to complete it, each extra hour you put into the project will only result in slight improvements in quality. If you still continue putting more time into the project, you might actually end up decreasing its quality through over-tweaking.
Learning a new thing: Whether it is learning a new language, a new sport, or even working at a new company, you tend to have a very steep learning curve in the first few months. After the first few months, you have learnt most of the things and therefore your learning curve slows down.
Eating: If you give a child a piece of chocolate, they will be very happy. If you keep giving them more chocolate, they will continue gobbling it up, although with much less enthusiasm compared to the first piece of chocolate. If you continue giving them more pieces of chocolate, the marginal utility of the chocolate will keep reducing to the point where they will say that they do not want any more chocolate.
Recreation: Playing your favorite game or spot, watching a movie, or even hanging out at your favorite joint feels great especially if you needed to unwind. However, the more you keep doing it, the more its marginal utility keeps decreasing. If you keep at it, negative utility kicks in, and you might even start feeling drained from doing something you usually enjoy doing.
In San Jose (CA), we meet Co-Founder & VP of Technology of Aquantia, Ramin Farjad-Rad. Ramin talks …
In San Francisco, we meet co-founder and Chairman of udemy, Eren Bali. He shares his story how …