What Is The Law Of Diminishing Marginal Returns? (With Examples)

The law of diminishing marginal returns is a crucial economic principle that holds significant relevance for businesses, particularly in production and operational settings. As industries evolve, understanding this concept can help organizations optimize their productivity and profitability.

To illustrate this economic principle effectively, we will return to our hypothetical Factory X, which specializes in manufacturing cogs and gizmos. We’ll explore how various changes in production factors can influence output, efficiency, and profitability.

Key Takeaways:

• The law of diminishing marginal returns states that as additional units of a production factor are added, the incremental output eventually decreases.

• For the law to apply, technology must remain constant, with only one production factor being altered.

• There are three stages of diminishing returns: increasing returns, diminishing returns, and negative returns.

• Economies of scale occur when increasing production factors lead to higher output, while diseconomies of scale happen when more production factors result in reduced output.

• Diseconomies of scale differ from diminishing marginal returns as they manifest over longer time frames.

Defining the Law of Diminishing Marginal Returns

The law of diminishing marginal returns is an economic theory that asserts that beyond a certain optimal production level, adding additional units of a production factor results in progressively smaller increases in output.

In simpler terms, adding more of a resource in a production process does not always lead to a proportional increase in output. For instance, integrating a second computer monitor may enhance work efficiency, but adding a third monitor might yield no further productivity gains.

Before examining Factory X, let’s clarify some relevant concepts:

• Economics. While often conflated with accounting, economics is a broader social science that examines how individuals and societies allocate resources, produce goods, and distribute services. It focuses on behaviors and interactions within the economy.

• Marginal return. This term refers to the return gained from a slight increase in investment, whether in terms of revenue from selling an additional product or the output achieved by hiring one more employee.

The law of diminishing marginal returns posits that increasing one production factor while keeping others constant will eventually lead to reduced output after reaching an optimal level.

For the law to hold true, two conditions must be satisfied:

• Technology remains constant. Throughout our examples, it’s important to understand that the law assumes only one variable changes at a time. If technology is upgraded or expanded, the principle may not apply.

• Only one input is altered. If multiple inputs change simultaneously, the relationship between inputs and outputs can vary significantly, resulting in different outputs.

These assumptions are critical for the validity of the law, so keep them in mind as we explore our examples.

Example of the Law of Diminishing Marginal Returns

Now, let’s delve into Factory X, which is operating smoothly, meeting demand, and generating solid profits. The factory manager decides to add one extra worker to the existing team of one. Initially, profits should double.

Next, imagine the workforce grows from 50 to 51 employees, aiming for a 2% output increase. However, when the team expands to 100 and then 102, the lack of changes in equipment or workspace can lead to inefficiencies. The expected output boost may not materialize because the production environment becomes congested.

What seemed like a straightforward business model—more employees equals more profits—might falter. Here, diminishing returns become evident as the anticipated profit growth begins to decline.

Stages of Diminishing Returns

The law of diminishing marginal returns can be distilled into a simple concept: change one factor of production while keeping others constant, and output will eventually decrease. However, this journey unfolds in three distinct stages:

• Stage one: Increasing returns. In this initial stage, adding resources can boost production significantly. For example, adding one employee to a one-person team can enhance efficiency and output.

• Stage two: Diminishing returns. At this stage, production approaches optimal efficiency. A slight change may push the operation past this point, leading to decreased output. For example, increasing from 50 to 51 employees may yield expected increases, but transitioning to 100 employees may lead to reduced productivity due to lack of space and resources.

• Stage three: Negative returns. Continuing to add resources beyond the optimal point can lead to negative returns. In this scenario, increased workforce size leads to inefficiencies, and production may suffer as workers become overcrowded and unproductive.

Through this example, it becomes clear that while adding employees can initially boost productivity, without proportional increases in equipment or workspace, the benefits can quickly diminish.

Economies and Diseconomies of Scale

Understanding the law of diminishing marginal returns also requires knowledge of economies and diseconomies of scale.

These principles, while interrelated, can be easily confused. Learning them together can provide valuable insights:

• Economies of scale. This occurs when increasing production leads to lower costs per unit, allowing businesses to become more efficient. For instance, a mass-produced sweater may cost significantly less than a handmade one due to bulk purchasing and efficient production processes.

• Diseconomies of scale. This term describes the situation where increasing production leads to inefficiencies and higher costs. For example, if Factory X hires too many employees without upgrading equipment or expanding workspace, the operation may become counterproductive, resulting in wasted resources and reduced profitability.

Diminishing Marginal Returns and Economies of Scale

To summarize, diminishing marginal returns occur in the short term when one production factor is increased while others remain constant, resulting in decreased output after an optimal point. In contrast, diseconomies of scale manifest over the long term, where production inefficiencies lead to increased costs.

Examples of the Law of Diminishing Marginal Returns

Here are additional scenarios demonstrating the law of diminishing marginal returns at Factory X:

1. Example 1

   Factory X decides to introduce a new cog-making machine, the only variable being changed. However, without staff to operate it, the investment fails to produce any output, resulting in wasted resources.

2. Example 2

   The gizmo department operates efficiently with two employees producing 20 gizmos daily. Adding a third employee boosts production to 30, but adding a fourth results in only 28 due to space constraints, demonstrating diminishing returns.

3. Example 3

   Mary, who fertilizes the flowers weekly, achieves great results. When Frank takes over and increases fertilization to twice a week, the flowers thrive. However, he pushes it to daily fertilization, leading to wilting and damage—an example of exceeding optimal input.

Frequently Asked Questions

1. Why is the law of diminishing marginal returns important?

The law of diminishing marginal returns is vital for understanding how increasing production factors can sometimes lead to decreased efficiency. This knowledge enables businesses, economists, and consumers to effectively monitor company performance and avoid the pitfalls of assuming that increased input will always yield greater output.

2. What is the point of diminishing returns?

The point of diminishing returns is reached when additional production factors result in a decline in output. This signifies the onset of diminishing returns, where productivity begins to wane despite further investment in resources.

Author

Kristin Kizer

Kristin Kizer is an award-winning writer, television and documentary producer, and content specialist who has worked on a wide variety of written, broadcast, and electronic publications. A former writer/producer for The Discovery Channel, she is now a freelance writer and delighted to be sharing her talents and time with the wonderful Zippia audience.