Law of Diminishing Marginal Returns

What is the Law of Diminishing Marginal Returns?

The law of diminishing marginal returns states that after an optimal amount of capacity increasing the inputs results in a decreased amount of outputs. In other words, after a critical point of increase, the outputs start to decrease for every unit of input invested in a production system. Although additional input after the optimum level decreases the output, the law does not imply this directly.

For the law of diminishing returns to hold good, all other factors of the system must remain constant. The law is also known as the Law of Increasing Costs because adding an additional unit consumes more output, increasing the cost of production. The law of diminishing returns is applicable to short-term-based production as in the case of the long-term systems, all fixed factors tend to be variable.

Examples of Diminishing Returns

Many examples of diminishing returns can be considered from various organizations.

Example 1

Let's assume that a company uses computer systems to manage accounting systems. There are 10 units of a computer system that does the job completely. Now, if the 11th system is added, it will only reduce the average output and increase the costs of the company. This is an example of diminishing marginal returns.

Example 2

Another example of diminishing marginal returns can be found in transportation. Suppose 10 metro rails can carry the required passengers from the originating platform to the destination platform without needing any extra train to carry the passengers on any given weekday. Now, if the metro rail corporation introduces another rail to carry passengers on the same route, it will reduce the efficiency of each train and also add extra cost to the corporation. The extra train is, therefore, an example of an extra unit of the law of diminishing marginal returns.

Diminishing Marginal Returns vs. Returns to Scale

Diminishing marginal returns is a concept that is effective for a short time where one variable, such as the capital or labor is kept constant.

For example, in example 1 of metro rails above, the amount of capital spent is kept constant before the diminishing returns are implied.

In the case of returns to scale, however, there is an increase in all input variables. This phenomenon is referred to as Economies of Scale.

For example, in example 2 of computer systems above, let's guess there is a 200% increase in the accounting process. So, adding only one system will result in an increase of 10% addition of output which is an example of decreasing result to scale. However, if the introduction of five new systems (50%) results in a tripling of output (150%), this would be an example of economies of scale.

Working of Law of Diminishing Marginal Returns

For the law of diminishing marginal returns to work, there are two key factors that must be fulfilled. These factors are important because they are related to the environment of the production system and because they affect the production system substantially.

• All of the technologies involved in the production system to gauge the law of diminishing returns must stay constant. It is easy to guess why. If the technologies change, they will affect the input variable via which the law is testified.
• Moreover, technological changes also affect the marginal and average costs as well as the value of the product. So, to let the law of diminishing returns hold good, technological factors should remain the same.
• For the law of diminishing marginal returns to be true, only one input must vary. It is not possible to check whether the returns have changed due to a certain input if all input variables vary proportionately. That is why the law may not be applicable when there is a variance in more than one input.

Three Stages of Diminishing Returns

When all other input sets remain constant and only one input variable changes, the law of diminishing marginal utility goes through the following three stages:

Stage 1: Increasing Returns

In the first stage of the process, the addition of increasing units of inputs leads to increasing amounts of outputs. This happens because the fixed inputs are found to have an abundance in comparison to the variable ones. The increasing stage continues to provide increasing outputs until the diminishing stage is reached.

Stage 2: Diminishing Returns

The addition of more units increases the overall output in this stage too. However, the rate of increase of outputs decreases in proportion to inputs in this stage. This stage ends in the culmination of the maximum value of output possible to be produced by the given input. This means that the marginal product reaches the amount of zero. Any additional input after this crucial limit would only lead to a diminishing value of output.

Stage 3: Negative Returns

This is the ultimate and undesirable stage of all production processes. After the optimum stage of production is reached in the second stage of the diminishing returns theory, the addition of any more inputs will not only hurt the production process but also result in negative production of the outputs. Manufacturers are usually aware of the optimum levels of inputs which helps them decide when the manufacturing processes should be stopped.

Conclusion

The law of diminishing marginal returns is an important topic in economics because it is related to the optimum utilization of a production system. By using this law and knowing the optimum limit of the addition of inputs, the production of goods can be maximized without wasting any input. This is particularly helpful in manufacturing where negative returns may mean useless costs to the producers.

Moreover, the law also helps to reduce the extra raw materials that may hurt the overall manufacturing processes, which means, the use of raw materials is optimized. This can directly help the companies to reduce their burdens and improve profitability.

FAQs

Qns 1. Are the law of marginal utility and the law of marginal returns related?

Ans. Yes. The law of marginal utility which tells that increasing consumption provides less satisfaction and the law of marginal returns which tells increasing the use of inputs after a certain point reduces the output are related.

In fact, the law of marginal returns is the law of marginal utility at its optimum input level.

Qns 2. At which stage of diminishing returns should the companies be?

Ans. To be optimally productive, the companies should be at the first stage of the diminishing returns theory because the productivity is maximum at this stage. However, staying in the selected stage is not easy because production is a continuous process and the stages occur naturally if not controlled externally.

Qns 3. Why is the negative stage of diminishing returns unacceptable?

Ans. The third or final stage of diminishing returns hurts the overall production process and may lead to waste. It is just unnecessary to take the production process to this level without any need for extra inputs that do not create affordable outputs. That is why it is avoidable.