Law of Diminishing Returns

The law of diminishing returns is an economic principle. The principle states that after a certain optimal point has been reached, an additional factor of production causes a relatively smaller increase in output.

Understanding the law of diminishing returns

In a production process, increases in the production factor cause the output to also increase.

At some point, however, an optimal output level is reached before it starts to decrease.

Production factors are another term for inputs and may include machine hours, raw materials, or labor.

Once this point has been reached and assuming that production factors are constant, each additional unit of a production factor causes a smaller increase in output.

Production output improvements, otherwise known as marginal outputs, start to diminish as efficiencies are limited by other production factors.

Since a point exists where adding extra units of production factor becomes inefficient, businesses need to determine the point where marginal returns start to diminish.

This is referred to as the point of diminishing returns.

Real-world applications of the law of diminishing returns

Some of the world’s earliest economists were aware of a point at which returns started to diminish. These included David Ricardo, James Anderson, and Thomas Robert Malthus.

Ricardo was the first to show how capital and labor added to land would result in progressively smaller output increases.

Malthus applied the idea of diminishing returns to population growth, positing that geometric food growth compared to arithmetic food production growth would cause a population to outgrow its food supply.

The law of diminishing returns is also relevant to numerous modern industries outside of farming and agriculture.

One example is social media marketing where a business may increase its ad spend, accidentally flood a channel with information, and cause its advertisement ROI to markedly decrease.

Companies that operate call centers must also determine the optimal number of customer service representatives.

In other words, at what point does an excessive number of personnel cause customer satisfaction to decrease? 

Determining the total cost of the output can be problematic if the company decides to measure a metric such as customer satisfaction that is hard to quantify.

A better approach is to measure service level, or the number of calls a rep answers over a predetermined period. The company can continue to recruit personnel to ensure staff are not overwhelmed and miss calls.

At the point of diminishing returns, however, an excess of staff will cause the service level to decrease as individuals essentially sit idle whilst waiting for a new customer service request.

Key takeaways:

  • The law of diminishing returns is an economic principle. It states that after a certain optimal point has been reached, an additional factor of production causes a relatively smaller increase in output.
  • Since a point exists where adding extra units of production factor becomes inefficient, businesses need to determine the point of diminishing returns where marginal output starts to decrease.
  • The law of diminishing returns is often mentioned in the context of farming and agriculture, but it can also be applied to modern examples such as social media marketing and call center operation.

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