The Law of Diminishing Returns

Imagine there’s a new startup that builds software solutions for customers. The startup has an office with ten computers and it decided to hire new software developers. It begins by hiring five workers. After a certain period, the demand for their services expands. The startup then decides to hire two more workers. This also is not enough to meet the demand, so the startup continues to hire new workers. However, after a certain period, it realises that the office is getting packed and the workers are confused and can’t work efficiently.

This is when the law of diminishing returns comes in. Instead of the new workers bringing in more output for the startup, they actually cause more cost. The law of diminishing returns states that a company starts experiencing diminishing returns after a certain point. A bit confused? Don’t worry. This explanation will help you learn everything you need to know about the law of diminishing returns.

Law of diminishing returns meaning

The Law of Diminishing Returns is an economic concept that suggests that as a business increases the amount of one input factor (such as labour) while keeping other inputs constant (such as capital and land), the marginal productivity of that input will eventually decrease. In simpler terms, the more you add of a single input, the less effective it becomes in producing additional output.

A firm maximises profit when it employs an optimal level of inputs, which is the lowest point of cost for which profit is maximised. Essentially, firms maximise profits by having a balance between their revenues and expenses.

You might think that the more input a firm adds to the production processes, the higher its revenues and profits will be. However, that is not always the case:

Table 1. Law of diminishing returns

The values in the table above are from a firm that produces chocolate bars in the short run. They start with one worker, but then continually add an extra worker. The values for TP are the number of chocolate bars produced in an hour.

From the first two columns, we can calculate the values for MP.

\(\hbox{Marginal Product} = \frac{\Delta\hbox{ Total Product (TP)}}{\Delta\hbox{Quantity (Q)}}\)

As the change in the number of workers (quantity) is always zero, the marginal product is just the change in total product.

Now, focusing on the marginal product row, we can see that it rises but then starts to fall. This is what the law of diminishing returns states:

While employing more labour (factor of production), there was an increase in the total number of chocolate bars produced. But at the margin, each additional increase in the workforce resulted in a smaller increase in output.

Eventually, hiring more workers resulted in a negative marginal output. This means that the seventh worker was not efficient in the production process. This doesn’t mean that the new workers didn’t have the necessary skills. It simply points out the production process becoming inefficient.

It is important to remember that this law is only applicable in the short run because most of the factors of production are fixed. For example, it’s not easy to increase land and capital in the short term as it takes time, but in the long run, these factors are variable (can easily be changed).

Assumptions of the law of diminishing returns

There are a couple of assumptions of the law of diminishing returns that we need to consider:

1. Short run: The law of diminishing returns applies to the short run period only. This means that the production process cannot be changed in the short run.
2. Fixed input: The law of diminishing returns assumes that at least one input factor is fixed while the other input factors are variable. For example, the quantity of land or capital is fixed, while the quantity of labor is variable.
3. Homogeneous units of inputs: The inputs used in the production process are assumed to be homogeneous or of the same quality. This means that each unit of input has the same productivity level as the other units.
4. Fixed technology: The technology used in the production process is assumed to be fixed. This means that the same production process is used regardless of the quantity of inputs used.

Law of diminishing returns graph

We can illustrate the law of diminishing marginal returns with a graph, which is seen in Figure 1 below.

When the law begins to operate, we have an increasing slope — the total output per additional unit of input increases. Initially, each new worker brings increasing marginal returns and increasing total product.

The point of maximum returns shows the maximum number of workers that should be hired if both total product and marginal returns are to be maximised.

After this point, marginal returns are on a decreasing function. This is what the law of diminishing returns explains.

Therefore we can say that there are three stages of the law of diminishing returns:

1. Increase of marginal returns.
2. Maximum marginal returns.
3. Diminishing marginal returns.

Application of the law of diminishing returns

The law of diminishing returns has applications almost in all industries but in some sectors more than others.

Agriculture is one of the primary industries where you can easily observe this law applied. The land is fixed capital, and the more workers one employs, the more inefficient the harvesting process will become. The output produced per additional worker hired to work on the farm will quickly drop.

Extractive industries such as fisheries or mines also have diminished returns in their production process. As more fishermen catch fish, extracting fish from the sea becomes more complex.

Importance of the law of diminishing returns

The importance of the law of diminishing returns lies in its ability to help businesses and individuals make informed decisions about how much to invest in a particular project.

Firms can use this to calculate whether hiring an additional worker benefits the firm or just creates additional costs. This helps the firm choose an optimal combination of labour and capital in the production process. As a result, firms are capable of maximising their profits.

The law of diminishing returns is also essential for population growth. There’s only a fixed amount of land which could fit all of us. Population growth might contribute to increased total output, but there will come the point where the additional work produced by an individual will start decreasing.

Another important task of the law of diminishing returns is pointing out the productivity of labour or capital.

The UK has recently experienced a decrease in labour productivity compared to other countries such as the United States. There are many reasons why labour productivity has dropped in the UK. Taking into account the law of diminishing returns, the UK can adjust their policies to help improve labour productivity.