Many economic principles have been around for years. They have stood the test of time to various degrees, but overall they still hold true even when modern production techniques and skills are factored into them. One of these principles of ‘diminishing returns’ has been stretched a little but still remains true to this day. Let’s take a look at the principle of diminishing returns or the ‘law of diminishing returns’ as it is sometimes also known by.
What is the Principle of Diminishing Returns?
This is an economic principle that simply states that if all factors of production remain constant except for one, the one variable factor that does change will eventually get to a point where when one more unit of that variable is added it will actually start lessening the returns on the amount of the product produced.
How Diminishing Returns Theory Works
Here is an example of how the principle of diminishing returns works. Agricultural examples are typically used to explain diminishing returns because it is easy to understand them when only one variable is being changed. We will stick with that idea too.
Let’s take an apple orchard as the type of business we are looking at. Of course in order for the orchard to produce a profit for the owner, the trees must produce apples and then these must be picked and then sold to a buyer. For the example purposes, the number of apples that can be picked in total and the price the apples are sold for will remain constant.
The land owner added workers until he figured out it took 10 workers to have the orchard completely picked in the required one month’s time. Say each worker cost $100 a month and they picked 1000 apples that were sold for 25 cents each. That will give the landowner a profit of $150 on each worker for a total of $1500 on the year’s crop.
The economic variable that will change in our scenario is the number of pickers. If one more picker is added to the equation, those 11 workers will cost the landowner $1100 to pick all the apples. Since everything else stayed the same, the landowners profit decreased $100 to $1400. The owner might have gotten the apples picked faster, but there was no benefit from doing that, so the land owner experienced a ‘diminishing return’ on their production of $100.
The Problem with Using Diminishing Returns in an Economic Model
One of the things that make this economic principle tough to apply in modern times is the fact that very seldom is there a situation where only one variable changes in production while the rest stay constant. Modern society pricing is largely based on supply and demand, and that means pricing can change by the minute. Workers also earn different amounts of money based on such things as time spent working for an employer, individual skills and education level; individual workers also contribute to only portions of the production process in most cases. All these things make it hard to make production variables constant.
But one thing that still holds true about diminishing returns is the fact that if a company can hold most factors of production at or near a constant level, they will still see that by changing one variable they will eventually get to a point where it is not worth the cost or effort to increase that variable factor anymore.