Law Of Diminishing Marginal Returns: What It Is And Examples

By Chris Kolmar - Jan. 12, 2021
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The Law of Diminishing Marginal Returns is an interesting concept, and it’s one that’s vital to many businesses, especially in a factory setting where production is key to success. To explain this economics principle in the most efficient way, we will use the same imaginary factory for our examples.

Factory X makes cogs and gizmos. Let’s look at how the factory works and how changes can affect the output, performance, and ultimately the profits of Factory X. We’ll also see the law of diminishing returns in action.

Definition of the Law of Diminishing Marginal Returns

Before we dive into Factory X, let’s take a minute to understand the concepts at work here and a few terms:

  • Economics. Many people think of economics as something similar to accounting. Both have to do with the economy, but they’re vastly different. Think of accounting as having to do with money and finances. Economics is more theoretical and is broader reaching.

    It’s a social science that studies people and how they react to things like money. But economics also looks at how people interact with goods, services, the production of these items, and distribution. It’s a more encompassing view of the economy.

  • Marginal return. This is a harder concept to understand. Marginal return is the rate of return (or how much you get back) from a marginal (slight) increase in investment.

    It can be how much money you get for selling one more item or how many more items you can produce by adding one more person, for example.

  • Diminishing. The word diminishing means less, basically.

When you put all of those terms together, you can begin to understand the definition a little more deeply, but it helps set us up to explain it.

The economic principle of the Law of Diminishing Marginal Returns means that if you have a productive process and you increase one factor of production while changing nothing else, that the output will decrease.

If you thought you understood the concept, that might have made it a little bit more confusing. So let’s look at an example.

Example of the Law of Diminishing Marginal Returns

Let’s go over to Factory X. Factory X is humming along, making their cogs and gizmos. They’re meeting demand and making a pretty good profit. Then the factory manager decides if they add one person to the one-person cog team. Now there are two people making profits, and their profits should double.

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What if there are 50 people making cogs, and they increase the crew by 2%, which means adding one more person to the team. Now you have a team of 51 people making cogs, and you will theoretically increase output by 2%.

A bit later, there are 100 people on the cog team; they again want to increase by 2%, which would mean adding another two people. The problem is, in all of this time, there hasn’t been a change in anything else. Why? That’s a part of the economics theory. You’re only changing one variable.

Now you’ve got a clogged up machine and floor space that simply can’t accommodate 102 people. At this point, you can’t count on that 2% increase in profits. In fact, you can plan for it to raise less than 2%. Suddenly, what you thought you could count on as a business model (increase people = increase in profits) has changed. And there are your diminishing returns. At some point, there will be less profit for the same increases.

The Stages of Diminishing Returns

Often, the law of diminishing marginal returns is simplified to the concept that if you change one thing in your effective process, while everything else is the same, eventually you’ll get less out of it. But it’s not quite that simple; it takes time.

In fact, you go through three stages of diminishing returns:

  • Stage one: Increasing returns. In this stage, changing one thing can improve your returns. Adding one person to the one-person team can be more efficient and increase the amount of cogs that Factory X can produce.

  • Stage two: Diminishing returns. Now you’re working up toward optimal efficiency. Using the most of the set factors possible and producing the most product.

    A slight change will push you out of that sweet spot, and you’ll start getting less output or a decrease in production. This is the point where you can record diminishing returns.

    Factory X added 102 people, and now they can’t work as efficiently, and they’re not going to see the 2% return they saw when they went from 50 to 51 people. Remember, nothing else changed, except for the addition of more people.

  • Stage three: Negative returns. If you keep pushing, upping that one factor, to try to recover and make more, you’ll find even more diminishing returns, and you’ll head into a negative return situation.

    Factory X realizes it’s making less with 102 people, so they figure adding even more people will boost production again, but now they’ve added so many that there’s no room to move, and the world is flooded with cogs, and nobody wants any – they already have all they can use.

Here you can see that adding an employee but changing nothing else can boost your production. More people can work faster and get more done and out the door. But if you’re not adding more machines or increasing your factory size, at some point, adding people isn’t going to help.

In fact, they’ll just get in the way. Keep adding people, and suddenly nobody can move or get their job done, and your production drops dramatically.

Economies and Diseconomies of Scale

Now that you understand the concept behind the Law of Diminishing Marginal Return, it’s essential to also touch on the economies of scale and the diseconomies of scale.

These two economic principles can be confusing, and it’s easy to get them all intertwined in your head. If you learn about them both at once, it can help tremendously.

  • Economies of scale. This is the cost savings a company gets when they have an efficient production process. It happens when they’ve increased production, and this leads to the lowering of their costs.

    It’s important to understand that when it comes to economies of scale – size matters. A lot!

    Think of it this way, you can get a red sweater that’s handmade by an artist at an art fair, and it costs $200. It’s a good price when you consider how much time she put into it and the expense of the yarn to her.

    Now, you go to a big box store, and you see a similar red sweater that’s mass-produced in a factory that cranks out a ton of them a day.

    They get discounts on the yarn because they buy in bulk. They can afford to pay many people to make these sweaters. And they’re not handknitted; they’re made by machines that do it in a small fraction of the time that your textile artist above needed. This sweater costs $20.

    The artist made one sweater in a month, and she spent $100 on the yarn and countless hours making it. She’s not getting much of a profit when you break it out.

    The company produced one sweater in 10 minutes and spent $10 on yarn. They sell hundreds of these sweaters and are making a considerable profit. And that is economies of scale.

    The more you can spread the costs of production out, the more you’ll make. It also leads to lower per-unit costs, meaning you’re going to get more buyers.

  • Diseconomies of scale. Is the point where you go from making more product means making more money to making more product does not lead to more sales; in fact, it eventually becomes unprofitable.

    Once again, Factory X is at it, increasing its gizmo producing output this time. They wanted to do as well as their cogs division, so they jumped right in and added 100 employees. Of course, no new machines were added, and there’s no additional floor space. They expected to make a huge profit, but that didn’t happen.

    Factory X’s gizmo division is paying a lot of people to stand around and get in each other’s way. Most of them aren’t even working, and the ones that are are having a hard time getting quality products out of the factory. This increases your costs to run the business and decreases your profits.

    They’re no longer seeing the benefits that come from being a big player in the market. They’re now wasting money on employees, putting out shoddy gizmos, and destroying their brand’s reputation. Where they once were efficient, and it didn’t cost much to make one gizmo, now they’re paying too much to make one and not making a profit.

Diminishing Marginal Returns and Economies of Scale.

The key takeaway is that diminishing marginal returns is what happens in the short run when you increase one area of production and nothing else. You hit a point where your production output decreases because of the increase in that one area.

Diseconomies of scale happens when you are making so much product, but there are so many inefficiencies in the warehouse that it costs more to make each one. This is more of a long-run scenario.

Examples of the Law of Diminishing Marginal Returns

Here are a few more ways Factory X can experience the Law of Diminishing Marginal Returns:

Example 1

Factory X decides it needs a new cog-maker. This machine is the one variable they will change in the company. They add it to the company floor, taking up valuable space. Still, they can’t add another employee as they’re only changing one variable due to the rules of this economic theory.

You can easily see that with no one to run the machine, it’s not practical and won’t produce anything. They’ve spent money that can’t be recouped.

Example 2

The gizmo department is running well with two employees, and those two employees make 20 gizmos a day. They add another employee, and they’re getting 30 gizmos. It feels like adding one more will give them 40 gizmos, but they realize they’re only getting 32 when they have four employees.

It turns out that they don’t have enough equipment or floor space for four employees to work, so one of them is usually standing around. Adding a fifth employee makes the work floor even more wasteful and difficult to maneuver in; now, they’re only turning out 28 gizmos.

Example 3

We move out of Factory X and take a break in their outdoor garden. Mary fertilizes the flowers once a week, and they’re glorious. Everybody loves Mary’s flowers.

While Mary is taking a leave of absence, Frank takes over the gardening and decides to fertilize twice a week, so the flowers look better under his watch. And they do. Then he decides to fertilize every day for even better results. Unfortunately, all of the flowers start to wilt and droop. Too much fertilizer can damage plants, and that’s exactly what happened. Poor Frank.

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Chris Kolmar

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Chris Kolmar

Chris Kolmar is a co-founder of Zippia and the editor-in-chief of the Zippia career advice blog. He has hired over 50 people in his career, been hired five times, and wants to help you land your next job. His research has been featured on the New York Times, Thrillist, VOX, The Atlantic, and a host of local news. More recently, he's been quoted on USA Today, BusinessInsider, and CNBC.

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