Law of Diminishing Returns

views updated

Law of Diminishing Returns

What It Means

The law of diminishing returns, one of the best-known economic ideas, concerns the production of goods or services. In the production of any good or service, there are “inputs” and “output.” Inputs are all of those things required to make the good, such as land, labor, machinery, and raw materials. Output is the sum of all the final products that these inputs are able to generate. In a simple farming operation, for instance, the inputs might include four laborers, 100 acres of land, one tractor, one truck, and seeds. Using these inputs, the farm might be able to produce an output of 500 bushels of corn.

The law of diminishing returns addresses what happens when one input in the production process is increased while the others are held steady. If, for instance, the farm in the above example sets out to increase output, it might start hiring new workers. But if all the other inputs stayed the same, there would eventually be a point at which the increases in output, per worker, would begin to diminish. Past that point, the output produced by each worker would be less than the output produced by the smaller number of workers at an earlier stage of the farm’s development.

While the law of diminishing returns results in decreased output, it does not necessarily have a bearing on the farm’s profitability. In business a profit is the amount of money an individual or company earns through output after accounting for input expenses. For example, if a farmer spends $10,000 a month on production costs (equipment, materials, labor, land-related expenses, and so on) and earns $12,000 a month in crop sales, then the farmer’s profit (commonly known as a profit margin) is $2,000 a month—or, $200 per $1,000 spent on operational costs. In this respect, the farm is profitable.

Using the same example, say the farmer hires two additional laborers at an additional cost of $2,000 per month, bringing his total operational expenses to $12,000. If his total monthly earnings increase to $14,300—or, roughly $192 per $1,000 spent—then the farmer has seen diminishing returns on his hiring of two additional workers; however, the farmer has still increased his total profit, from $2,000 to $2,300. In this sense, while the hiring of two additional workers resulted in diminishing returns, it also resulted in greater profits.

When Did It Begin

The first appearances of the concept that we now call the law of diminishing returns can be found in the writings of several early economists, such as those of the eighteenth-century French statesman, writer, and economist A.J. P. Turgot. The concept came to the fore of the work of two of the most important nineteenth-century economists, Thomas Malthus and David Ricardo, both of whom lived and worked in England.

Malthus and Ricardo, writing in the early decades of that century, both worried about England’s population relative to the amount of food and other goods that could be produced in the country. Malthus believed that England’s population was growing faster than its capacity to produce food and that the end result would be a nightmarish catastrophe. Ricardo did not agree entirely with Malthus’s doomsday predictions, but he also noted that increased inputs did not always result in proportional increases in output. Malthus, Ricardo, and economists that came after established the idea that, as population expanded, the output per person would inevitably decline.

More Detailed Information

Diminishing returns begin at the point when the proportion of all the other inputs (land, raw materials, machinery) falls relative to the input that is changed. There is only so much corn, obviously, that can be grown on 100 acres of land, using one tractor, one truck, and a constant number of seeds. At first, the farmer might find that with only four workers, some of those other inputs (the land, the tractor, the truck, the seeds) were not being fully utilized. Maybe after he increases his workforce to six laborers, he finds that those six people use those inputs more efficiently than the original four did. But he might find that, at eight employees, he has lost efficiency. It might be that with eight bodies on 100 acres, the workers begin to get in one another’s way, or they spend too much time waiting around to use the available equipment. At any rate, if the farmer finds that his expanding workforce does not produce a proportional expansion of output, diminishing returns have begun. If the farmer keeps hiring workers, the amount of output per worker will continue to diminish.

The same principle would apply if it were another input being changed. For example, imagine that the farmer keeps his workforce stable at four employees, maintains all the other inputs at their original levels (100 acres, one tractor, and one truck), but increases the number of seeds he plants by one-half. He might initially find that this increases his output proportionately (by one-half), which encourages him to increase the number of seeds yet again. Once he has increased his seed count by double the original amount, however, he might find that his output begins to diminish. If double the amount of seeds only yields one and three-quarters the output he produced initially, then he has reached the point of diminishing returns. If he goes on to add even more seeds, his return per seed will continue to drop.

Recent Trends

One of the reasons that the law of diminishing returns does not necessarily result (as early economists believed it would, in a situation where population increases faster than the world’s food production capacity) is the existence of technology. The early economists understated (or did not take into account at all) the effect of new technologies on production. Similarly, the law of diminishing returns assumes a situation in which technology, like all the other inputs, is constant. If the farmer in the above example started using a dramatically effective new fertilizer, for instance, the law of diminishing returns might not take effect at the same point. He might be able to triple output by doubling the number of seeds he plants. With this drastic increase in the food supply, further expansion of the population will be much less problematic.

In countries where new technology is not always readily accessible or implemented, however, the effects of the law of diminishing returns become clear. If production methods remain unchanged for long periods of time, economic stagnation is the norm.

About this article

Law of Diminishing Returns

Updated About content Print Article