The Law of Diminishing Returns

The Law of Diminishing Returns

The law of diminishing returns states that as a business continues to increase the quantity of one factor of production (e.g. labour) while keeping the quantity of the other factor fixed (e.g. capital), the marginal product will increase initially and then start to decrease. A marginal product is an additional output that arises from an increase in input by one more unit. Total product is the output resulting from the use of all factors in production while average product is output per unit of variable factor employed. Marginal product is obtained by dividing the change in total product by change in the amount of the variable factor employed. The total product divided by the quantity of variable factor is the average product. The law of diminishing returns happens in the short run. It is also known as the law of variable proportions or the principle of diminishing marginal productivity.

 

Why does the marginal product eventually fall?
There are more than enough units of the fixed factor, such as capital, at the start. Additional variable factors or workers hired are more productive as they have a lot of fixed factors to work with. The marginal product keeps increasing until it gets to a point when all the fixed factors are fully utilised. If more workers are subsequently added, their output will be falling as there is no enough capital to use.

 

A numerical example
The law of diminishing returns sets in when the marginal product begins to drop. In Table 1 below, the law started when the 4th worker was employed as marginal product was reduced from 30 to 28 units.  Average product will later start to decrease as can be seen in the table. Total product was actually increasing at a decreasing rate and it was at the maximum level when the marginal product was zero. Total product begins to fall when marginal product is negative. This is illustrated in Figure 1 below.

Table 1: Illustration of the law of diminishing returns

Capital

Labour

Total Product

Average Product

Marginal Product

3

0

0

3

1

10

10

10

3

2

30

15

20

3

3

60

20

30

3

4

88

22

28

3

5

115

23

27

3

6

115

19.2

0

3

7

105

15

-10

3

8

80

10

-25



Figure 1:  Total Product, Average Product and Marginal Product

 

 

The law of diminishing returns forms the basis of the short run costs
The marginal cost will fall in the beginning as each additional unit of the variable factor (worker) produces more than the one before it. And there is a larger increase in output than costs as one more factor unit is employed. It will get to a point where the productivity of additional factor unit will begin to decline leading to a rise in marginal cost (see Figure 2 below). This is when diminishing returns begins as there is no enough additional output to cover the additional cost associated with utilising the extra factor unit. Then average cost, as well, begins to rise as the marginal cost rises; the total costs are increasing but there is less marginal product so the rate at which output increases is falling.

Figure 2: Short run costs