The Law of Diminishing Marginal Returns

Definition: Law of diminishing marginal returns

At a certain point, employing an additional factor of production causes a relatively smaller increase in output.

Diminishing returns occur in the short run when one factor is fixed (e.g. capital)
If the variable factor of production is increased (e.g. labour), there comes a point where it will become less productive and therefore there will eventually be a decreasing marginal and then average product.
This is because, if capital is fixed, extra workers will eventually get in each other’s way as they attempt to increase production. For example, think about the effectiveness of extra workers in a small café. If more workers are employed, production could increase but more and more slowly.
This law only applies in the short run because, in the long run, all factors are variable.

The Law of diminishing marginal returns explained

Assume the wage rate is £20, then an extra worker costs £20.
The Marginal Cost (MC) of a sandwich will be the cost of the worker divided by the number of extra sandwiches that are produced
Therefore as MP increases MC declines and vice versa
Total Product (TP) This is the total output produced by workers
Marginal Product (MP) This is the output produced by an extra worker.

The first worker adds two goods. If a worker costs £20. The MC of those two units is 20/2 = 10.
The 3^rd worker adds six goods. The MC of those six units are 20/6 = 3.3
The 5^th worker adds an extra ten goods. The MC of these 10 is just 2.
After the 5^th worker, diminishing returns sets in, as the MP declines. As extra workers produce less, the MC increases.

Why Diminishing Returns Happens

Imagine you own a cafe of medium size. If you tried to run the cafe on your own you would be overwhelmed. Hiring more workers initially will increase productivity because

Specialisation – A barista can make drinks, a waiter can serve tables, manager do books
Better use of fixed capital
Teamwork

But after a certain point, hiring more workers will start to give diminishing returns

Too many workers crowd the fixed workspace
Capital becomes over-used – There is queue of workers waiting to use the coffee machine
Workers interfere with each other. Congestion behind the counter.
Productivity per extra worker falls. Workers are no longer efficient.

Diagram of diminishing returns

In this example, after three workers, diminishing returns sets in.
After employing 4 workers or more – the marginal product (MP) of the worker declines and the marginal cost (MC) starts to rise.

In this case, diminishing returns occurs after output 5.

Difference between diminishing returns and dis-economies of scale

Diminishing returns relate to the short run – higher SRAC. Diseconomies of scale is concerned with the long run. Diseconomies of scale occur when increased output leads to a rise in LRAC – e.g. after Q4, we get a rise in LRAC.
At output Q1, we get diminishing returns, shown by SRAC1.
If the factory, increases capital, we can get a different outcome, shown by SRAC2. But, we still get diminishing returns in the short run.

Examples of diminishing returns

Use of chemical fertilisers. A good example of diminishing returns includes the use of chemical fertilisers- a small quantity leads to a big increase in output. However, increasing its use further may lead to declining Marginal Product (MP) as the efficacy of the chemical declines.
Revising into the early hours of the morning. If you revise economics for six hours a day, you will improve your knowledge quite a bit. However, if you continue to revise into the early hours of the morning, the amount that you learn increases by only a small amount because you are tired.
Employing extra workers. A cafe may wish to serve more customers during the busy summer months. However, employing extra workers may be difficult because of a lack of space in the cafe.
Employing more taxi drivers when a company has a fixed number of taxis. The extra drivers may be unable to work, leading to uncaptured marginal product.

Diminishing marginal returns to wealth

Another example of diminishing marginal returns could be with regard to wealth. As your wealth increases, initially, your happiness rises as you are able to buy food to eat and a place to live. But, after a certain level of wealth, gaining more wealth doesn’t lead to any rise in happiness. As the old saying goes “money can’t buy happiness”.

Further reading