Law of Diminishing Returns

Law of Diminishing Returns Definition

Law of diminishing returns states that an additional amount of a single factor of production will result in a decreasing marginal output of production. The law assumes other factors to be constant. What this means is that if X produces Y, there will be a point when adding more quantities of X will not help in a marginal increase in quantities of Y.

law of diminising returns graph

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Law of Diminishing Returns (wallstreetmojo.com)

In the above graph of the law of diminishing returns, as factor X rises from 1 unit to 2 units, the number of Y increases. But as the quantities of X rise further to P, production assumes a decreasing rate till Yp. This describes the law above. Another noticeable aspect is that there comes a point when a further increase in units of X will only reduce the production of Y. Thus, not only does increasing input affect marginal product but also the total product.  This law is mostly applicable in a production setting.

Components of the Law of Diminishing Returns

From the definition of the law of diminishing returns, there are three components.

Components of Law of diminishing returns

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Law of Diminishing Returns (wallstreetmojo.com)

  1. Factor of Production – Any input that generates a desired quantity of output. With regard to the law of diminishing returns, only one factor at a time is considered.
  2. Marginal Product – With every additional input, the increase in total product is referred to as the marginal product. In the graph above, Y2-Y1 is the marginal product.
  3. Total Product – When an input is applied through a process, the result or outcome as an aggregate measure is the total product.

Assumptions of Law of Diminishing Marginal Returns

  • The law is used mostly by taking a short-run production scenario into consideration. This is because the principle lies in keeping all other factors of production as constant, except the one used to correlate with output. This is not possible in a long-run view of production.
  • The input and the process(es) should be held independent of technological aspects as technology can play its part in improving efficiencies in production.

Examples of Law of Diminishing Marginal Returns

Below are the examples of the law of diminishing returns.

You can download this Law of Diminishing Returns Excel Template here – Law of Diminishing Returns Excel Template

Example #1

Suppose that a factory produces a certain good given by the following equation:

Q = -L3 + 27L2 + 15L

Where,

Q is the quantity of production

L is the input in terms of labor

Describe if the law of diminishing returns applies, if yes how?

Solution:

In order to check the applicability of this law, we will quantify units of production by assuming different values of labor input.

law of diminising returns Example 1

We plot the values of Q and L on a graph for analysis. Y-axis represents the Product (total and marginal). The x-axis represents units of labor.

law of diminising returns Example 1-1

In the above law of  diminishing return graph, two points are critical to the law:

  • Point A – the limiting marginal product, and
  • Point B – the limiting total product.

Following points are worth noting:

We can divide this production graph into 2 stages with regard to the marginal output.

  1. As labor input increases, the marginal product also increases before a number of workers, L = 9. This is the stage of increasing returns.
  2. The marginal product produced by the 11th unit of labor is less than the 10th This begins the stage of diminishing returns.

The total product i.e. quantity of Q does not decrease before the 20th worker is employed.  Clearly, the marginal product enters the stage of negative returns from here.

The factory can employ 9 workers to keep the marginal product at a rising rate. However, it can add as many as 19 workers before noting a fall in the total product.

Example #2

A farmer owns a small wheat field. He starts cultivating his land with one laborer. He gradually increases it to six laborers only to find that his wheat output has not proportionately increased. Help the farmer out in analyzing the optimal workforce required.

returns Example 2

Solution:

By simply looking at the wheat output as against the labor used, we can say that the marginal output is decreasing with each additional labor deployed. If we deduce the marginal product and present it to the farmer, it will look like:

returns Example 2-1

This shows that the marginal product increases before the services of the 4th laborer are taken. After that, the marginal product decreases.

Hence, the farmer should optimize his wheat output with 3 laborers on his field.

On the other hand, he can maximize his total product by continuing to increase laborers.  But this comes at a cost of reduced marginal output.

These two examples from a good stage from where we can look at the advantages and limitations of the “law of diminishing returns”.

Advantages of the Law of Diminishing Returns

  • Law of diminishing returns helps management maximize labor (as in example 1 & 2 above) and other factors of production to an optimum level.
  • This theory also helps in increasing the efficiency of production by minimizing production costs as evident from the wheat farmer’s case.

Limitations of Law of Diminishing Returns

  • Although useful in production activities, this law cannot be applied in all forms of production. The constraint comes when the factors of production are less natural and hence a universal application is difficult. Mostly this law finds its application in agricultural scenarios.
  • The law assumes that all units of a single factor of production must be identical. This is however not practical usually and becomes a hurdle in an application. In our above examples, labor becomes the specific input, other factors held constant.

Conclusion

The law of diminishing returns is a useful concept in production theory. The law can be categorized into three stages – increasing returns, diminishing returns and negative returns. Production industry and more particularly, the agriculture sector finds the immense application of this law. Producers question where to operate on the graph of the marginal product as the first stage describes underutilized capacity and the third stage is about overutilized inputs. Hence, to arrive at the optimum capacity is the rationale behind this law.

This has been a guide to the law of diminishing returns and its definition. Here we discuss the diagram of the law of diminishing marginal returns along with examples, advantages, and limitations. You can learn more about economics from the following articles –