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What Is the Law of Diminishing Returns?
The Law of Diminishing Returns states that when one element of production is incrementally increased, and all other elements stay the same, the value added is less than the investment made.
Say for example, an automobile factory decides to double its workforce. More workers on the floor may cause inefficiencies in process. This will lead to diminishing returns.
History of Diminishing Returns
While a number of different economists explored the idea of diminishing returns, Thomas Malthus and David Ricardo are commonly believed to have articulated the theory that lesser-quality inputs would leave to lower-volume outputs. The earliest applications of the Law of Diminishing Returns were to farming, but more contemporary applications include factories as well as industries that see technological advances.
Applying Diminishing Returns to Economics
Read through the following examples to see how the concept of diminishing returns applies to the broader framework of the economy.
Think of “too many cooks in the kitchen”: the kitchen is the company, and the variable factors include the cooks, the equipment, the ingredients, to name a few. The baseline of production is that one cook can make five plates of lasagna.
Say the kitchen wants to triple lasagna production, and they hire two more cooks. But those three cooks can only produce 11 plates of lasagna. Why? Possibly because there’s not enough physical room in the kitchen for the cooks to all be working at the same time. Or there’s a shortage of equipment, like the noodle maker or the stove, or the oven. If more cooks were added, the total output would go up at an increasingly smaller rate. This is an example of the Law of Diminishing Returns (also called the Law of Diminishing Marginal Returns)—with increased investment (cooks), the returns on the lasagna kitchen are still increasing, but at a diminishing (or lesser) rate.
Now let’s say the kitchen decided to add another cook, far past its most optimal setup, and kept all other variable factors the same. The kitchen, barely able to accomodate the cooks already within it, would struggle to keep up with making plates of lasagna. The output would grow then stagnate in the short run, but eventually start going down.
This is the Law of Negative Returns—that with further increased investment, the returns actually start decreasing.
Increasing Marginal Returns (or Diminishing Costs)
The Law of Increasing Marginal Returns (or Diminishing Costs) relies on a similar concept to the Law of Diminishing Returns: as long as all variables are kept at a constant, the Law of Increasing Marginal Returns predicts there will be an incremental increase in total production and efficiency, and a decreasing rate in the costs of running business.
But this requires that all factors of production continue running smoothly. If the noodle maker gets jammed or the oven breaks, the more cooks that are added to the kitchen, the longer it will take to produce the same output as before and the marginal costs will start to accrue, instead of going down.
In any place of production, be it a factory, a farm, a lasagna kitchen, or an office of software developers, the factors of production like number of workers, number of machines or computers, or amount of fertilizer used, can be adjusted to increase production. Adjusting and investing in these variable factors will lead the production process to gain marginal returns. However, at a certain point the increased investment in an additional factors of production will yield diminishing and then eventually negative returns, which is the Law of Diminishing Returns. It is the responsibility of those in charge to work towards reaching an optimal equilibrium.