law-of-diminishing-returns

Law of Diminishing Returns

Business / By / October 16, 2023

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.

AspectExplanation
Concept Overview– The Law of Diminishing Returns, also known as the Law of Diminishing Marginal Returns, is an economic principle that describes a phenomenon in which adding more units of a variable input (such as labor or capital) to a fixed input (such as land or machinery) in the production process eventually results in diminishing additional output. In simpler terms, as you increase one input while keeping others constant, the additional output gained from each additional unit of the input will decline. This concept is a fundamental element of microeconomics and production theory.
Key Characteristics– The Law of Diminishing Returns is characterized by several key features:
1. Fixed and Variable Inputs: It assumes that at least one factor of production remains fixed while others are varied.
2. Short-Run Phenomenon: It primarily applies to the short run, as in the long run, firms can adjust all inputs.
3. Marginal Returns: It focuses on changes in marginal (additional) output resulting from incremental changes in the variable input.
4. Non-Linearity: The relationship is non-linear, meaning that initially, marginal returns may increase, but they eventually decrease.
Illustrative Example– One common example of the Law of Diminishing Returns is in agriculture. Consider a fixed plot of land (the fixed input) and labor (the variable input). Initially, adding more labor to the land can increase crop yields significantly. However, after a certain point, additional labor may lead to overcrowding, resulting in decreased productivity per additional worker due to limited space and resources. The law helps farmers optimize resource allocation.
Production Functions– The Law of Diminishing Returns is often represented in production functions, such as the Cobb-Douglas production function. These functions express the relationship between inputs (labor, capital) and output (goods or services) and incorporate the concept of diminishing returns to scale. Understanding these functions helps firms make informed decisions about resource allocation.
Application in Business– Businesses use the Law of Diminishing Returns to make decisions about resource allocation, production levels, and cost management. By recognizing the point at which additional inputs yield diminishing returns, firms can optimize production processes and resource utilization to minimize costs and maximize profitability. It also informs decisions about scale and expansion.
Optimal Resource Allocation– Understanding the Law of Diminishing Returns is crucial for optimal resource allocation. It helps determine the optimal level of input (such as labor or capital) that maximizes output while minimizing costs. This balance is essential for maintaining efficiency and competitiveness in various industries.
Long-Run vs. Short-Run– The Law of Diminishing Returns primarily applies to the short run, where some inputs are fixed. In the long run, firms can adjust all inputs, which can lead to different production dynamics. Long-run analysis involves considerations of economies of scale, which can lead to increased returns as production expands. The short run highlights the immediate impact of input changes.
Policy Implications– Governments and policymakers may consider the Law of Diminishing Returns when formulating economic policies. It can inform decisions related to land use, environmental regulations, taxation, and resource allocation. Understanding production dynamics helps balance economic growth with resource sustainability.
Technological Advancements– Technological innovations can sometimes mitigate the effects of the Law of Diminishing Returns. New technologies, improved processes, and better resource management can extend the point at which diminishing returns occur or even lead to increasing returns to scale. Technological progress plays a significant role in economic growth.
Diversification and Risk Management– Businesses often diversify their operations or invest in research and development to reduce reliance on a single product or process, thereby mitigating the impact of diminishing returns in specific areas. Diversification can help manage risk and maintain long-term competitiveness.
Real-World Considerations– In the real world, factors other than just inputs can influence production. These include technological advancements, market demand, external shocks, and management efficiency. As a result, the Law of Diminishing Returns serves as a simplified model for understanding production dynamics and making informed decisions rather than an absolute rule governing all situations.
Strategic Decision-Making– Businesses use insights from the Law of Diminishing Returns to make strategic decisions about expanding, downsizing, diversifying, or optimizing their operations. Recognizing when and where diminishing returns occur is essential for achieving sustainability and profitability in the long run.

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.

Key Highlights

  • Principle of Diminishing Returns:
    • The law of diminishing returns is an economic principle that states that after a certain optimal point, adding more of a production factor will lead to a relatively smaller increase in output.
  • Production Factors and Output:
    • In a production process, as production factors (inputs) increase, the output also increases initially.
  • Optimal Output Level:
    • However, there’s a point at which optimal output is reached, after which further increases in production factors result in decreasing output.
  • Marginal Output and Efficiency:
    • As production factors continue to increase beyond the optimal point, the improvements in output (marginal output) start diminishing due to limitations imposed by other factors.
  • Point of Diminishing Returns:
    • The point at which marginal returns start diminishing is referred to as the point of diminishing returns.
  • Historical Perspective:
    • Early economists like David Ricardo, James Anderson, and Thomas Robert Malthus recognized the concept of diminishing returns.
    • Ricardo demonstrated how adding capital and labor to land leads to progressively smaller output increases.
    • Malthus applied the idea to population growth and food supply.
  • Modern Applications:
    • Diminishing returns are relevant beyond agriculture, such as in social media marketing and call center operations.
    • For instance, excessive ad spending in social media marketing can lead to decreased advertisement ROI.
    • Call centers need to find the optimal number of customer service representatives to maintain service level without overwhelming staff.
  • Determining Optimal Points:
    • Businesses need to determine the optimal points where additional input becomes inefficient.
    • Measuring metrics like customer satisfaction or service level can help decide the optimal number of resources.
    • Too many resources beyond the optimal point can lead to decreased output and efficiency.
  • Relevance to Various Industries:
    • While often mentioned in agriculture, the law of diminishing returns applies to various industries, where finding the right balance of resources is crucial.

Connected Economic Concepts

Market Economy

market-economy
The idea of a market economy first came from classical economists, including David Ricardo, Jean-Baptiste Say, and Adam Smith. All three of these economists were advocates for a free market. They argued that the “invisible hand” of market incentives and profit motives were more efficient in guiding economic decisions to prosperity than strict government planning.

Positive and Normative Economics

positive-and-normative-economics
Positive economics is concerned with describing and explaining economic phenomena; it is based on facts and empirical evidence. Normative economics, on the other hand, is concerned with making judgments about what “should be” done. It contains value judgments and recommendations about how the economy should be.

Inflation

how-does-inflation-affect-the-economy
When there is an increased price of goods and services over a long period, it is called inflation. In these times, currency shows less potential to buy products and services. Thus, general prices of goods and services increase. Consequently, decreases in the purchasing power of currency is called inflation. 

Asymmetric Information

asymmetric-information
Asymmetric information as a concept has probably existed for thousands of years, but it became mainstream in 2001 after Michael Spence, George Akerlof, and Joseph Stiglitz won the Nobel Prize in Economics for their work on information asymmetry in capital markets. Asymmetric information, otherwise known as information asymmetry, occurs when one party in a business transaction has access to more information than the other party.

Autarky

autarky
Autarky comes from the Greek words autos (self)and arkein (to suffice) and in essence, describes a general state of self-sufficiency. However, the term is most commonly used to describe the economic system of a nation that can operate without support from the economic systems of other nations. Autarky, therefore, is an economic system characterized by self-sufficiency and limited trade with international partners.

Demand-Side Economics

demand-side-economics
Demand side economics refers to a belief that economic growth and full employment are driven by the demand for products and services.

Supply-Side Economics

supply-side-economics
Supply side economics is a macroeconomic theory that posits that production or supply is the main driver of economic growth.

Creative Destruction

creative-destruction
Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.

Happiness Economics

happiness-economics
Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.

Oligopsony

oligopsony
An oligopsony is a market form characterized by the presence of only a small number of buyers. These buyers have market power and can lower the price of a good or service because of a lack of competition. In other words, the seller loses its bargaining power because it is unable to find a buyer outside of the oligopsony that is willing to pay a better price.

Animal Spirits

animal-spirits
The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage.  Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.

State Capitalism

state-capitalism
State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.

Boom And Bust Cycle

boom-and-bust-cycle
The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.

Paradox of Thrift

paradox-of-thrift
The paradox of thrift was popularised by British economist John Maynard Keynes and is a central component of Keynesian economics. Proponents of Keynesian economics believe the proper response to a recession is more spending, more risk-taking, and less saving. They also believe that spending, otherwise known as consumption, drives economic growth. The paradox of thrift, therefore, is an economic theory arguing that personal savings are a net drag on the economy during a recession.

Circular Flow Model

circular-flow-model
In simplistic terms, the circular flow model describes the mutually beneficial exchange of money between the two most vital parts of an economy: households, firms and how money moves between them. The circular flow model describes money as it moves through various aspects of society in a cyclical process.

Trade Deficit

trade-deficit
Trade deficits occur when a country’s imports outweigh its exports over a specific period. Experts also refer to this as a negative balance of trade. Most of the time, trade balances are calculated based on a variety of different categories.

Market Types

market-types
A market type is a way a given group of consumers and producers interact, based on the context determined by the readiness of consumers to understand the product, the complexity of the product; how big is the existing market and how much it can potentially expand in the future.

Rational Choice Theory

rational-choice-theory
Rational choice theory states that an individual uses rational calculations to make rational choices that are most in line with their personal preferences. Rational choice theory refers to a set of guidelines that explain economic and social behavior. The theory has two underlying assumptions, which are completeness (individuals have access to a set of alternatives among they can equally choose) and transitivity.

Conflict Theory

conflict-theory
Conflict theory argues that due to competition for limited resources, society is in a perpetual state of conflict.

Peer-to-Peer Economy

peer-to-peer-economy
The peer-to-peer (P2P) economy is one where buyers and sellers interact directly without the need for an intermediary third party or other business. The peer-to-peer economy is a business model where two individuals buy and sell products and services directly. In a peer-to-peer company, the seller has the ability to create the product or offer the service themselves.

Knowledge-Economy

knowledge-economy
The term “knowledge economy” was first coined in the 1960s by Peter Drucker. The management consultant used the term to describe a shift from traditional economies, where there was a reliance on unskilled labor and primary production, to economies reliant on service industries and jobs requiring more thinking and data analysis. The knowledge economy is a system of consumption and production based on knowledge-intensive activities that contribute to scientific and technical innovation.

Command Economy

command-economy
In a command economy, the government controls the economy through various commands, laws, and national goals which are used to coordinate complex social and economic systems. In other words, a social or political hierarchy determines what is produced, how it is produced, and how it is distributed. Therefore, the command economy is one in which the government controls all major aspects of the economy and economic production.

Labor Unions

labor-unions
How do you protect your rights as a worker? Who is there to help defend you against unfair and unjust work conditions? Both of these questions have an answer, and it’s a solution that many are familiar with. The answer is a labor union. From construction to teaching, there are labor unions out there for just about any field of work.

Bottom of The Pyramid

bottom-of-the-pyramid
The bottom of the pyramid is a term describing the largest and poorest global socio-economic group. Franklin D. Roosevelt first used the bottom of the pyramid (BOP) in a 1932 public address during the Great Depression. Roosevelt noted that – when talking about the ‘forgotten man:’ “these unhappy times call for the building of plans that rest upon the forgotten, the unorganized but the indispensable units of economic power.. that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyramid.”

Glocalization

glocalization
Glocalization is a portmanteau of the words “globalization” and “localization.” It is a concept that describes a globally developed and distributed product or service that is also adjusted to be suitable for sale in the local market. With the rise of the digital economy, brands now can go global by building a local footprint.

Market Fragmentation

market-fragmentation
Market fragmentation is most commonly seen in growing markets, which fragment and break away from the parent market to become self-sustaining markets with different products and services. Market fragmentation is a concept suggesting that all markets are diverse and fragment into distinct customer groups over time.

L-Shaped Recovery

l-shaped-recovery
The L-shaped recovery refers to an economy that declines steeply and then flatlines with weak or no growth. On a graph plotting GDP against time, this precipitous fall combined with a long period of stagnation looks like the letter “L”. The L-shaped recovery is sometimes called an L-shaped recession because the economy does not return to trend line growth.  The L-shaped recovery, therefore, is a recession shape used by economists to describe different types of recessions and their subsequent recoveries. In an L-shaped recovery, the economy is characterized by a severe recession with high unemployment and near-zero economic growth.

Comparative Advantage

comparative-advantage
Comparative advantage was first described by political economist David Ricardo in his book Principles of Political Economy and Taxation. Ricardo used his theory to argue against Great Britain’s protectionist laws which restricted the import of wheat from 1815 to 1846.  Comparative advantage occurs when a country can produce a good or service for a lower opportunity cost than another country.

Easterlin Paradox

easterlin-paradox
The Easterlin paradox was first described by then professor of economics at the University of Pennsylvania Richard Easterlin. In the 1970s, Easterlin found that despite the American economy experiencing growth over the previous few decades, the average level of happiness seen in American citizens remained the same. He called this the Easterlin paradox, where income and happiness correlate with each other until a certain point is reached after at least ten years or so. After this point, income and happiness levels are not significantly related. The Easterlin paradox states that happiness is positively correlated with income, but only to a certain extent.

Economies of Scale

economies-of-scale
In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

diseconomies-of-scale
In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Economies of Scope

economies-of-scope
An economy of scope means that the production of one good reduces the cost of producing some other related good. This means the unit cost to produce a product will decline as the variety of manufactured products increases. Importantly, the manufactured products must be related in some way.

Price Sensitivity

price-sensitivity
Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.

Network Effects

negative-network-effects
In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

Negative Network Effects

negative-network-effects
In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

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Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
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