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In economics, diminishing returns

(also called diminishing marginal
returns) refers to how the marginal
production of a factor of production
starts to progressively decrease as the
factor is increased, in contrast to the
increase that would otherwise be
normally expected. According to this
relationship, in a production system
with fixed and variable inputs (say
factory size and labor), each
additional unit of the variable input
(i.e., man-hours) yields smaller and
smaller increases in outputs, also
reducing each worker's mean
productivity. Conversely, producing
one more unit of output will cost
increasingly more (owing to the
major amount of variable inputs
being used, to little effect).

This concept is also known as the

law of diminishing marginal
returns or the law of increasing
relative cost.

Contents:
1. Statement of the law
2. History
3. Examples
4. Returns and costs
5. Returns to scale
6. See also
7. References
8. Sources

1. Statement of the law

The law of diminishing returns has
been described as one of the most
famous laws in all of economics. [1] In
fact, the law is central to production

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theory, one of the two major

divisions of neoclassical
microeconomic theory. The law
states "that we will get less and less
extra output when we add additional
doses of an input while holding other
inputs fixed. In other words, the
marginal product of each unit of
input will decline as the amount of
that input increases holding all other
inputs constant." [2] Explaining
exactly why this law holds true has
sometimes proven problematic.

Diminishing returns and diminishing

marginal returns are not the same
thing. Diminishing marginal returns
means that the MPL curve is falling.
The output may be either negative or
positive. Diminishing returns means
that the extra labor causes output to
fall which means that the MPL is
negative. In other words the change
in output per unit increase in labor is
negative and total output is falling. [3]

2. History
The concept of diminishing returns
can be traced back to the concerns of
early economists such as Johann
Heinrich von Thünen, Turgot,
Thomas Malthus and David Ricardo.
However, classical economists such
as Malthus and Ricardo attributed the
successive diminishment of output to
the decreasing quality of the inputs.
Neoclassical economists assume that
each "unit" of labor is identical =
perfectly homogeneous. Diminishing
returns are due to the disruption of
the entire productive process as
additional units of labor are added to
a fixed amount of capital.

Karl Marx developed a version of the

law of diminishing returns in his
theory of the tendency of the rate of
profit to fall, described in Volume III
of Capital.

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3. Examples
Suppose that one kilogram of seed
applied to a plot of land of a fixed
size produces one ton of crop. You
might expect that an additional
kilogram of seed would produce an
additional ton of output. However, if
there are diminishing marginal
returns, that additional kilogram will
produce less than one additional ton
of crop (ceteris paribus). For
example, the second kilogram of seed
may only produce a half ton of extra
output. Diminishing marginal returns
also implies that a third kilogram of
seed will produce an additional crop
that is even less than a half ton of
additional output, say, one quarter of
a ton.

In economics, the term "marginal" is

used to mean on the edge of
productivity in a production system.
The difference in the investment of
seed in these three scenarios is one
kilogram — "marginal investment in
seed is one kilogram." And the
difference in output, the crops, is one
ton for the first kilogram of seeds, a
half ton for the second kilogram, and
one quarter of a ton for the third
kilogram. Thus, the marginal
physical product (MPP) of the seed
will fall as the total amount of seed
planted rises. In this example, the
marginal product (or return) equals
the extra amount of crop produced
divided by the extra amount of seeds
planted.

A consequence of diminishing
marginal returns is that as total
investment increases, the total return
on investment as a proportion of the
total investment (the average product
or return) decreases. The return from
investing the first kilogram is 1 t/kg.
The total return when 2 kg of seed
are invested is 1.5/2 = 0.75 t/kg,

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while the total return when 3 kg are

invested is 1.75/3 = 0.58 t/kg.

This particular example of

Diminishing Marginal Returns in
formulaic terms: Where =
Diminished Marginal Return, =

seed in kilograms, and = crop

yield in tons gives us:

Substituting 3 for and expanding

yields:

Another example is a factory that has

a fixed stock of capital, or tools and
machines, and a variable supply of
labor. As the firm increases the
number of workers, the total output
of the firm grows but at an ever-
decreasing rate. This is because after
a certain point, the factory becomes

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overcrowded and workers begin to

form lines to use the machines. The
long-run solution to this problem is to
increase the stock of capital, that is,
to buy more machines and to build
more factories.

4. Returns and costs

There is an inverse relationship
between returns of inputs and the cost
of production. Suppose that a
kilogram of seed costs one dollar, and
this price does not change; although
there are other costs, assume they do
not vary with the amount of output
and are therefore fixed costs. One
kilogram of seeds yields one ton of
crop, so the first ton of the crop costs
one extra dollar to produce. That is,
for the first ton of output, the
marginal cost (MC) of the output is
$1 per ton. If there are no other
changes, then if the second kilogram
of seeds applied to land produces
only half the output of the first, the
MC equals $1 per half ton of output,
or $2 per ton. Similarly, if the third
kilogram produces only ¼ ton, then
the MC equals $1 per quarter ton, or
$4 per ton. Thus, diminishing
marginal returns imply increasing
marginal costs. This also implies
rising average costs. In this numerical
example, average cost rises from $1
for 1 ton to $2 for 1.5 tons to $3 for
1.75 tons, or approximately from 1 to
1.3 to 1.7 dollars per ton.

In this example, the marginal cost

equals the extra amount of money
spent on seed divided by the extra
amount of crop produced, while
average cost is the total amount of
money spent on seeds divided by the
total amount of crop produced.

Cost can also be measured in terms of

opportunity cost. In this case the law
also applies to societies; the
opportunity cost of producing a

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single unit of a good generally

increases as a society attempts to
produce more of that good. This
explains the bowed-out shape of the
production possibilities frontier.

5. Returns to scale
The marginal returns discussed refer
to cases when only one of many
inputs is increased (for example, the
quantity of seed increases, but the
amount of land remains constant). If
all inputs are increased in proportion,
the result is generally constant or
increased output.

As a firm in the long-run increases

the quantities of all factors employed,
all other things being equal, initially
the rate of increase in output may be
more rapid than the rate of increase in
inputs, later output might increase in
the same proportion as input, then
ultimately, output will increase less
proportionately than input.

See also: economies of scale

6. See also
• Accelerating returns
• Learning curve and Experience
curve effects
• Diseconomies of scale, does
not assume fixed inputs, thus
differing from 'diminishing
returns'
• Diminishing marginal utility,
also not to be mistaken for
'diminishing returns'
• Increasing returns
• Marginal value theorem
• Moore's law
• Opportunity cost
• Tendency of the rate of profit
to fall

7. References

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1. Samuelson & Nordhaus,

Microeconomics, 17th ed. page
110. McGraw Hill 2001.
2. Samuelson & Nordhaus,
Microeconomics, 17th ed. page
110. McGraw Hill 2001.
3. Perloff, Microeconomics,
Theory and Applications with
Calculus page 178. Pearson
2008.

8. Sources
• Case, Karl E. & Fair, Ray C.
(1999). Principles of
Economics (5th ed.). Prentice-
Hall. ISBN 0-13-961905-4.

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modified: 2010-07-03 11:58:46

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