Diminishing returns

In economics, diminishing returns is the decrease in the marginal (incremental) output of a production process as the amount of a single factor of production is incrementally increased, while the amounts of all other factors of production stay constant.

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The law of diminishing returns states that in all productive processes, adding more of one factor of production, while holding all others constant ("ceteris paribus"), will at some point yield lower incremental per-unit returns.[1] The law of diminishing returns does not imply that adding more of a factor will decrease the total production, a condition known as negative returns, though in fact this is common.

A common example is adding more people to a job, such as the assembly of a car on a factory floor. At some point, adding more workers causes problems such as workers getting in each other's way or frequently finding themselves waiting for access to a part. In all of these processes, producing one more unit of output per unit of time will eventually require increasingly more usage of the input, due to the input being used less effectively.[2] Another well-studied example is throwing more headcount at software development, yielding Brooks's law.

The law of diminishing returns is a fundamental principle of economics.[1] It plays a central role in production theory.[3]

History

The concept of diminishing returns can be traced back to the concerns of early economists such as Johann Heinrich von Thünen, Jacques Turgot, Adam Smith,[4] James Steuart, Thomas Robert Malthus, and David Ricardo. However, classical economists such as Malthus and Ricardo attributed the successive diminishment of output to the decreasing quality of the inputs. Neoclassical economists assume that each "unit" of labor is identical. Diminishing returns are due to the disruption of the entire productive process as additional units of labor are added to a fixed amount of capital. The law of diminishing returns remains an important consideration in farming.

Example
As labor usage increases from L1 to L2, total output (measured vertically in the top graph) increases by the amount shown. But if labor usage is increased by the same amount again, output goes up by less, implying diminishing marginal returns to the use of labor as an input. The marginal product of labor (measured vertically in the bottom graph) is diminishing everywhere to the right of point A.

An example is a factory that has a fixed stock of capital, or tools and machines, and a variable supply of labor. As the firm increases the number of workers, the total output of the firm grows but at an ever-decreasing rate. This is because after a certain point, the factory becomes overcrowded and workers begin to form lines to use the machines. The long-run solution to this problem is to increase the stock of capital, that is, to buy more machines and to build more factories.

Returns and costs

There is an inverse relationship between returns of inputs and the cost of production, although other features such as input market conditions can also affect production costs. Suppose that a kilogram of seed costs one dollar, and this price does not change. Assume for simplicity that there are no fixed costs. One kilogram of seeds yields one ton of crop, so the first ton of the crop costs one dollar to produce. That is, for the first ton of output, the marginal cost as well as the average cost of the output is $1 per ton. If there are no other changes, then if the second kilogram of seeds applied to land produces only half the output of the first (showing diminishing returns), the marginal cost would equal $1 per half ton of output, or $2 per ton, and the average cost is $2 per 3/2 tons of output, or $4/3 per ton of output. Similarly, if the third kilogram of seeds yields only a quarter ton, then the marginal cost equals $1 per quarter ton or $4 per ton, and the average cost is $3 per 7/4 tons, or $12/7 per ton of output. Thus, diminishing marginal returns imply increasing marginal costs and increasing average costs.

Cost is measured in terms of opportunity cost. In this case the law also applies to societies – the opportunity cost of producing a single unit of a good generally increases as a society attempts to produce more of that good. This explains the bowed-out shape of the production possibilities frontier.

See also

References

Citations
  1. Samuelson, Paul A.; Nordhaus, William D. (2001). Microeconomics (17th ed.). McGraw-Hill. p. 110. ISBN 0071180664.
  2. George, Henry. The Science of Political Economy. New York: Robert Schalkenbach Foundation. Archived from the original on 2019-02-26. Retrieved 2014-04-25.
  3. Encyclopædia Britannica. Encyclopædia Britannica, Inc. 26 Jan 2013. ISBN 9781593392925.
  4. Smith, Adam. The wealth of nations. Thrifty books. ISBN 9780786514854.

Sources
  • Case, Karl E.; Fair, Ray C. (1999). Principles of Economics (5th ed.). Prentice-Hall. ISBN 0-13-961905-4.
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