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economics Economics () is the social science that studies the production, distribution, and consumption of goods and services. Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics analyzes ...
, diminishing returns are the decrease in marginal (incremental) output of a
production Production may refer to: Economics and business * Production (economics) * Production, the act of manufacturing goods * Production, in the outline of industrial organization, the act of making products (goods and services) * Production as a stati ...
process as the amount of a single
factor of production In economics, factors of production, resources, or inputs are what is used in the production process to produce output—that is, goods and services. The utilized amounts of the various inputs determine the quantity of output according to the rel ...
is incrementally increased, holding all other factors of production equal ( ceteris paribus). The law of diminishing returns (also known as the law of diminishing marginal productivity) states that in productive processes, increasing a factor of production by one unit, while holding all other production factors constant, will at some point return a lower unit of output per incremental unit of input. The law of diminishing returns does not cause a decrease in overall production capabilities, rather it defines a point on a production curve whereby producing an additional unit of output will result in a loss and is known as negative returns. Under diminishing returns, output remains positive, however
productivity Productivity is the efficiency of production of goods or services expressed by some measure. Measurements of productivity are often expressed as a ratio of an aggregate output to a single input or an aggregate input used in a production proces ...
and efficiency decrease. The modern understanding of the law adds the dimension of holding other outputs equal, since a given process is understood to be able to produce co-products. An example would be a factory increasing its saleable product, but also increasing its CO2 production, for the same input increase. The law of diminishing returns is a fundamental principle of both micro and macro economics and it plays a central role in
production theory Production is the process of combining various inputs, both material (such as metal, wood, glass, or plastics) and immaterial (such as plans, or knowledge) in order to create output. Ideally this output will be a good or service which has value a ...
. The concept of diminishing returns can be explained by considering other theories such as the concept of
exponential growth Exponential growth is a process that increases quantity over time. It occurs when the instantaneous rate of change (that is, the derivative) of a quantity with respect to time is proportional to the quantity itself. Described as a function, a ...
. It is commonly understood that growth will not continue to rise exponentially, rather it is subject to different forms of constraints such as limited availability of resources and capitalisation which can cause
economic stagnation Economic stagnation is a prolonged period of slow economic growth (traditionally measured in terms of the GDP growth), usually accompanied by high unemployment. Under some definitions, "slow" means significantly slower than potential growth as e ...
. This example of production holds true to this common understanding as production is subject to the four factors of production which are land, labour, capital and enterprise. These factors have the ability to influence economic growth and can eventually limit or inhibit continuous exponential growth. Therefore, as a result of these constraints the production process will eventually reach a point of maximum yield on the production curve and this is where marginal output will stagnate and move towards zero. However it should also be considered that innovation in the form of technological advances or managerial progress can minimise or eliminate diminishing returns to restore productivity and efficiency, and to generate profit. This idea can be understood outside of economics theory, for example, population. The population size on Earth is growing rapidly, but this will not continue forever (exponentially). Constraints such as resources will see the population growth stagnate at some point and begin to decline. Similarly, it will begin to decline towards zero, but not actually become a negative value. The same idea as in the diminishing rate of return inevitable to the production process.


History

The concept of diminishing returns can be traced back to the concerns of early economists such as
Johann Heinrich von Thünen Johann Heinrich von Thünen (24 June 1783 – 22 September 1850), sometimes spelled Thuenen, was a prominent nineteenth century economist and a native of Mecklenburg-Strelitz, now in northern Germany.He "ranks alongside Marx as the greatest Ge ...
, Jacques Turgot, Adam Smith, James Steuart,
Thomas Robert Malthus Thomas Robert Malthus (; 13/14 February 1766 – 29 December 1834) was an English cleric, scholar and influential economist in the fields of political economy and demography. In his 1798 book '' An Essay on the Principle of Population'', Ma ...
, and
David Ricardo David Ricardo (18 April 1772 – 11 September 1823) was a British political economist. He was one of the most influential of the classical economists along with Thomas Malthus, Adam Smith and James Mill. Ricardo was also a politician, and a ...
. However, classical economists such as Malthus and Ricardo attributed the successive diminishment of output to the decreasing quality of the inputs whereas Neoclassical economists assume that each "unit" of labor is identical. Diminishing returns are due to the disruption of the entire production process as additional units of labor are added to a fixed amount of capital. The law of diminishing returns remains an important consideration in areas of production such as farming and agriculture. Proposed on the cusp of the
First Industrial Revolution The Industrial Revolution was the transition to new manufacturing processes in Great Britain, continental Europe, and the United States, that occurred during the period from around 1760 to about 1820–1840. This transition included going fr ...
, it was motivated with single outputs in mind. In recent years, economists since the 1970s have sought to redefine the theory to make it more appropriate and relevant in modern economic societies. Specifically, it looks at what assumptions can be made regarding number of inputs, quality, substitution and complementary products, and output co-production, quantity and quality. The origin of the law of diminishing returns was developed primarily within the agricultural industry. In the early 19th century, David Ricardo as well as other English economists previously mentioned, adopted this law as the result of the lived experience in England after the war. It was developed by observing the relationship between prices of wheat and corn and the quality of the land which yielded the harvests. The observation was that at a certain point, that the quality of the land kept increasing, but so did the cost of produce etc. Therefore, each additional unit of labour on agricultural fields, actually provided a diminishing or marginally decreasing return.


Example

A common example of diminishing returns is choosing to hire more people on a factory floor to alter current manufacturing and production capabilities. Given that the capital on the floor (e.g. manufacturing machines, pre-existing technology, warehouses) is held constant, increasing from one employee to two employees is, theoretically, going to more than double production possibilities and this is called increasing returns. If we now employ 50 people, at some point, increasing the number of employees by two percent (from 50 to 51 employees) would increase output by two percent and this is called constant returns. However, if we look further along the production curve to, for example 100 employees, floor space is likely getting crowded, there are too many people operating the machines and in the building, and workers are getting in each other's way. Increasing the number of employees by two percent (from 100 to 102 employees) would increase output by less than two percent and this is called "diminishing returns." After achieving the point of maximum output, if we employ additional workers, this will give us negative returns. Through each of these examples, the floor space and capital of the factor remained constant, i.e., these inputs were held constant. However, by only increasing the number of people, eventually the productivity and efficiency of the process moved from increasing returns to diminishing returns. To understand this concept thoroughly, acknowledge the importance of marginal output or
marginal return Marginal Return is the rate of return for a marginal increase in investment; roughly, this is the additional output resulting from a one-unit increase in the use of a variable input, while other inputs are constant. See also *Diminishing returns ...
s. Returns eventually diminish because economists measure productivity with regard to additional units (marginal). Additional inputs significantly impact efficiency or returns more in the initial stages. The point in the process before returns begin to diminish is considered the optimal level. Being able to recognize this point is beneficial, as other variables in the production function can be altered rather than continually increasing labor. Further, examine something such as the
Human Development Index The Human Development Index (HDI) is a statistic composite index of life expectancy, education (mean years of schooling completed and expected years of schooling upon entering the education system), and per capita income indicators, wh ...
, which would presumably continue to rise so long as GDP per capita (in Purchasing Power Parity terms) was increasing. This would be a rational assumption because GDP per capita is a function of HDI. However, even GDP per capita will reach a point where it has a diminishing rate of return on HDI. Just think, in a low income family, an average increase of income will likely make a huge impact on the wellbeing of the family. Parents could provide abundantly more food and healthcare essentials for their family. That is a significantly increasing rate of return. But, if you gave the same increase to a wealthy family, the impact it would have on their life would be minor. Therefore, the rate of return provided by that average increase in income is diminishing.


Mathematics

Signify Output = O \ ,\ Input = I \ ,\ O = f(I) Increasing Returns: 2\cdot f(I) Constant Returns: 2\cdot f(I)=f(2\cdot I) Diminishing Returns: 2\cdot f(I)>f(2\cdot I)


Production Function

There is a widely recognised production function in economics: ''Q= f(NR, L, K, t, E)'': * The point of diminishing returns can be realised, by use of the second derivative in the above production function. *Which can be simplified to: ''Q= f(L,K)''. * This signifies that output (Q) is dependent on a function of all variable (L) and fixed (K) inputs in the production process. This is the basis to understand. What is important to understand after this is the math behind Marginal Product. ''MP= ΔTP/ ΔL.'' * This formula is important to relate back to diminishing rates of return. It finds the change in total product divided by change in labour. * The Marginal Product formula suggests that MP should increase in the short run with increased labour. However, in the long run, this increase in workers will either have no effect or a negative effect on the output. This is due to the effect of fixed costs as a function of output, in the long run.


Link with Output Elasticity

Start from the equation for the Marginal Product: = To demonstrate diminishing returns, two conditions are satisfied; marginal product is positive, and marginal product is decreasing. Elasticity, a function of Input and Output, \epsilon =\cdot, can be taken for small input changes. If the above two conditions are satisfied, then 0<\epsilon <1. This works intuitively; # If is positive, since negative inputs and outputs are impossible, # And is positive, since a positive return for inputs is required for diminishing ''returns'' * Then 0<\epsilon # is relative change in output, is relative change in input # The relative change in output is smaller than the relative change in input; ~input requires increasing effort to change output~ * Then /=\cdot=\epsilon < 1


Returns and costs

There is an inverse relationship between returns of inputs and the cost of production, although other features such as input market conditions can also affect production costs. Suppose that a kilogram of seed costs one
dollar Dollar is the name of more than 20 currencies. They include the Australian dollar, Brunei dollar, Canadian dollar, Hong Kong dollar, Jamaican dollar, Liberian dollar, Namibian dollar, New Taiwan dollar, New Zealand dollar, Singapore dollar, ...
, and this price does not change. Assume for simplicity that there are no
fixed cost In accounting and economics, 'fixed costs', also known as indirect costs or overhead costs, are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be recurring, such as interest or r ...
s. One kilogram of seeds yields one ton of crop, so the first ton of the crop costs one dollar to produce. That is, for the first ton of output, the marginal cost as well as the average cost of the output is 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 (showing diminishing returns), the marginal cost would equal per half ton of output, or per ton, and the average cost is per 3/2 tons of output, or /3 per ton of output. Similarly, if the third kilogram of seeds yields only a quarter ton, then the marginal cost equals per quarter ton or per ton, and the average cost is per 7/4 tons, or /7 per ton of output. Thus, diminishing marginal returns imply increasing marginal costs and increasing average costs. Cost is measured in terms of opportunity cost. In this case the law also applies to societies – the opportunity cost of producing a 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 Production may refer to: Economics and business * Production (economics) * Production, the act of manufacturing goods * Production, in the outline of industrial organization, the act of making products (goods and services) * Production as a stat ...
.


Justification


Ceteris Paribus

Part of the reason one input is altered ''ceteris paribus'', is the idea of disposability of inputs. With this assumption, essentially that some inputs are above the efficient level. Meaning, they can decrease without perceivable impact on output, after the manner of excessive fertiliser on a field. If input disposability is assumed, then increasing the principal input, while decreasing those excess inputs, could result in the same 'diminished return', as if the principal input was changed certeris paribus. While considered as 'hard' inputs, like labour and assets, diminishing returns would hold true. In the modern accounting era where inputs can be traced back to movements of financial capital, the same case may reflect constant, or increasing returns. It is necessary to be clear of the 'fine structure' of the inputs before proceeding. In this, ceteris paribus is disambiguating.


See also

*
Diminishing marginal utility In economics, utility is the satisfaction or benefit derived by consuming a product. The marginal utility of a good or service describes how much pleasure or satisfaction is gained by consumers as a result of the increase or decrease in consumpti ...
, also not to be mistaken for 'diminishing returns' * Diseconomies of scale, does not assume fixed inputs, and considers costs, thus differing from 'diminishing returns' *
Economies of scale In microeconomics, economies of scale are the cost advantages that enterprises obtain due to their scale of operation, and are typically measured by the amount of output produced per unit of time. A decrease in cost per unit of output enables ...
*
Gold plating (project management) In time management, gold plating is the phenomenon of working on a project or task past the point of diminishing returns. Phenomenon For example: after having met the requirements, the project manager or the developer works on further enhancing t ...
*
Learning curve A learning curve is a graphical representation of the relationship between how proficient people are at a task and the amount of experience they have. Proficiency (measured on the vertical axis) usually increases with increased experience (the ...
and Experience curve effects *
Liebig's Law of the minimum Liebig's law of the minimum, often simply called Liebig's law or the law of the minimum, is a principle developed in agricultural science by Carl Sprengel (1840) and later popularized by Justus von Liebig. It states that growth is dictated not by t ...
* Marginal value theorem * Opportunity cost * Returns to scale *
Pareto efficiency Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engi ...
*
Self-organized criticality Self-organized criticality (SOC) is a property of dynamical systems that have a critical point as an attractor. Their macroscopic behavior thus displays the spatial or temporal scale-invariance characteristic of the critical point of a phase ...
* Submodular set function * Sunk-cost fallacy *
Tendency of the rate of profit to fall The tendency of the rate of profit to fall (TRPF) is a theory in the crisis theory of political economy, according to which the rate of profit—the ratio of the profit to the amount of invested capital—decreases over time. This hypothesis ...
*
Analysis paralysis Analysis paralysis (or paralysis by analysis) describes an individual or group process where overanalyzing or overthinking a situation can cause forward motion or decision-making to become "paralyzed", meaning that no solution or course of acti ...
*
Teamwork Teamwork is the collaborative effort of a group to achieve a common goal or to complete a task in the most effective and efficient way. This concept is seen within the greater framework of a team, which is a group of interdependent individua ...
*
Amdahl's law In computer architecture, Amdahl's law (or Amdahl's argument) is a formula which gives the theoretical speedup in latency of the execution of a task at fixed workload that can be expected of a system whose resources are improved. It states tha ...


References


Citations


Sources

* {{Authority control Economics laws Production economics