Law of Diminishing Returns

Business / By / June 21, 2022

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.

Related Visual Concepts:

einstellung-effect
Maslow’s Hammer, otherwise known as the law of the instrument or the Einstellung effect, is a cognitive bias causing an over-reliance on a familiar tool. This can be expressed as the tendency to overuse a known tool (perhaps a hammer) to solve issues that might require a different tool. This problem is persistent in the business world where perhaps known tools or frameworks might be used in the wrong context (like business plans used as planning tools instead of only investors’ pitches).
peter-principle
The Peter Principle was first described by Canadian sociologist Lawrence J. Peter in his 1969 book The Peter Principle. The Peter Principle states that people are continually promoted within an organization until they reach their level of incompetence.
straw-man-fallacy
The straw man fallacy describes an argument that misrepresents an opponent’s stance to make rebuttal more convenient. The straw man fallacy is a type of informal logical fallacy, defined as a flaw in the structure of an argument that renders it invalid.
streisand-effect
The Streisand Effect is a paradoxical phenomenon where the act of suppressing information to reduce visibility causes it to become more visible. In 2003, Streisand attempted to suppress aerial photographs of her Californian home by suing photographer Kenneth Adelman for an invasion of privacy. Adelman, who Streisand assumed was paparazzi, was instead taking photographs to document and study coastal erosion. In her quest for more privacy, Streisand’s efforts had the opposite effect.
heuristic
As highlighted by German psychologist Gerd Gigerenzer in the paper “Heuristic Decision Making,” the term heuristic is of Greek origin, meaning “serving to find out or discover.” More precisely, a heuristic is a fast and accurate way to make decisions in the real world, which is driven by uncertainty.
recognition-heuristic
The recognition heuristic is a psychological model of judgment and decision making. It is part of a suite of simple and economical heuristics proposed by psychologists Daniel Goldstein and Gerd Gigerenzer. The recognition heuristic argues that inferences are made about an object based on whether it is recognized or not.
representativeness-heuristic
The representativeness heuristic was first described by psychologists Daniel Kahneman and Amos Tversky. The representativeness heuristic judges the probability of an event according to the degree to which that event resembles a broader class. When queried, most will choose the first option because the description of John matches the stereotype we may hold for an archaeologist.
take-the-best-heuristic
The take-the-best heuristic is a decision-making shortcut that helps an individual choose between several alternatives. The take-the-best (TTB) heuristic decides between two or more alternatives based on a single good attribute, otherwise known as a cue. In the process, less desirable attributes are ignored.
biases
The concept of cognitive biases was introduced and popularized by the work of Amos Tversky and Daniel Kahneman in 1972. Biases are seen as systematic errors and flaws that make humans deviate from the standards of rationality, thus making us inept at making good decisions under uncertainty.
bundling-bias
The bundling bias is a cognitive bias in e-commerce where a consumer tends not to use all of the products bought as a group, or bundle. Bundling occurs when individual products or services are sold together as a bundle. Common examples are tickets and experiences. The bundling bias dictates that consumers are less likely to use each item in the bundle. This means that the value of the bundle and indeed the value of each item in the bundle is decreased.
barnum-effect
The Barnum Effect is a cognitive bias where individuals believe that generic information – which applies to most people – is specifically tailored for themselves.

Read Next: Heuristics, Biases.

Main Free Guides:

Scroll to Top
FourWeekMBA
[class^="wpforms-"]
[class^="wpforms-"]