DIMINISHING MARGINAL RETURN

In economics, diminishing returns (also called diminishing marginal returns) refers to how

the marginal production of a factor of production starts to progressively decrease as the factor is

increased, in contrast to the increase that would otherwise be normally expected. According to

this relationship, in a production system with fixed and variable inputs (say factory size and

labor), each additional unit of the variable input (i.e., man-hours) yields smaller and smaller

increases in outputs, also reducing each worker's mean productivity. Conversely, producing one

more unit of output will cost increasingly more (owing to the major amount of variable inputs

being used, to little effect).

This concept is also known as the law of diminishing marginal returns or the law of

increasing relative cost.

Statement of the law

The law of diminishing returns has been described as one of the most famous laws in all of

economics.[1] In fact, the law is central to production theory, one of the two major divisions of

neoclassical microeconomic theory. The law states "that we will get less and less extra output

when we add additional doses of an input while holding other inputs fixed. In other words, the

marginal product of each unit of input will decline as the amount of that input increases holding

all other inputs constant."[2] Explaining exactly why this law holds true has sometimes proven

problematic.

Diminishing returns and diminishing marginal returns are not the same thing. Diminishing

marginal returns means that the MPL curve is falling. The output may be either negative or

positive. Diminishing returns means that the extra labor causes output to fall which means that

the MPL is negative. In other words the change in output per unit increase in labor is negative and

total output is falling.[3]

History

This section requires expansion.

The concept of diminishing returns can be traced back to the concerns of early economists such

as Johann Heinrich von Thünen, Turgot, Thomas 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 = perfectly homogeneous. 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.

Karl Marx developed a version of the law of diminishing returns in his theory of the tendency of

the rate of profit to fall, described in Volume III of Capital.

Examples

Suppose that one kilogram of seed applied to a plot of land of a fixed size produces one ton of

crop. You might expect that an additional kilogram of seed would produce an additional ton of

output. However, if there are diminishing marginal returns, that additional kilogram will produce

less than one additional ton of crop (ceteris paribus). For example, the second kilogram of seed

may only produce a half ton of extra output. Diminishing marginal returns also implies that a

third kilogram of seed will produce an additional crop that is even less than a half ton of

additional output, say, one quarter of a ton.

In economics, the term "marginal" is used to mean on the edge of productivity in a production

system. The difference in the investment of seed in these three scenarios is one kilogram —

"marginal investment in seed is one kilogram." And the difference in output, the crops, is one ton

for the first kilogram of seeds, a half ton for the second kilogram, and one quarter of a ton for the

third kilogram. Thus, the marginal physical product (MPP) of the seed will fall as the total

amount of seed planted rises. In this example, the marginal product (or return) equals the extra

amount of crop produced divided by the extra amount of seeds planted.

A consequence of diminishing marginal returns is that as total investment increases, the total

return on investment as a proportion of the total investment (the average product or return)

decreases. The return from investing the first kilogram is 1 t/kg. The total return when 2 kg of

seed are invested is 1.5/2 = 0.75 t/kg, while the total return when 3 kg are invested is 1.75/3 =

0.58 t/kg.

This particular example of Diminishing Marginal Returns in formulaic terms: Where D =

Diminished Marginal Return, X = seed in kilograms, and = crop yield in tons gives us:

Substituting 3 for X and expanding yields:

Another 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. Suppose

that a kilogram of seed costs one dollar, and this price does not change; although there are other

costs, assume they do not vary with the amount of output and are therefore fixed costs. One

kilogram of seeds yields one ton of crop, so the first ton of the crop costs one extra dollar to

produce. That is, for the first ton of output, the marginal cost (MC) 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, the MC equals $1 per half ton of output, or $2 per ton. Similarly, if

the third kilogram produces only ¼ ton, then the MC equals $1 per quarter ton, or $4 per ton.

Thus, diminishing marginal returns imply increasing marginal costs. This also implies rising

average costs. In this numerical example, average cost rises from $1 for 1 ton to $2 for 1.5 tons

to $3 for 1.75 tons, or approximately from 1 to 1.3 to 1.7 dollars per ton.

In this example, the marginal cost equals the extra amount of money spent on seed divided by the

extra amount of crop produced, while average cost is the total amount of money spent on seeds

divided by the total amount of crop produced.

Cost can also be 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.

Returns to scale

The marginal returns discussed refer to cases when only one of many inputs is increased (for

example, the quantity of seed increases, but the amount of land remains constant). If all inputs

are increased in proportion, the result is generally constant or increased output.

As a firm in the long-run increases the quantities of all factors employed, all other things being

equal, initially the rate of increase in output may be more rapid than the rate of increase in inputs,

later output might increase in the same proportion as input, then ultimately, output will increase

less proportionately than input.