Diminishing Returns in the Short Run

Readers Question: Explain why firms experience diminishing returns in the short run.

In the short run, we assume one factor of production (capital) is fixed. This is common sense – we can’t build a bigger factory overnight. Therefore, if we want to increase production, a firm can only increase the variable quantity – labour.

As we employ more workers, there will come a point when the marginal product of extra workers falls.

Think of a small cafe producing sandwiches. Two workers may be able to produce 20 sandwiches per hour. However, if you employ a third worker, they may only add an extra 5 sandwiches (we say his marginal product is 5 sandwhiches). His lower productivity is because space is now limited in the cafe; perhaps there is a queue to use the chopping board or get to the fridge. If you employed a 4th worker, the output may only increase by 1 or 2. A 5th worker may not actually increase output at al. It is this declining productivity that is the diminishing returns.

In the long run, a firm can increase its capital. e.g. the cafe could invest in extra space and a second fridge. This might mean a third worker would now be more productive. But, the cafe would still have diminishing returns at some point e.g. 8 workers.

- The Law of diminishing returns