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Law of Diminishing Returns

Definition

A condition after a process reaches an optimal state where adding more resources yields a minimal increase in production and reduces profitability.

Why Use It

The law illustrates a moment on the production curve where an additional unit results in negative returns or a loss. There is no reduction in output but rather a decrease in efficiency and productivity.

The value obtained from increasing one output but maintaining others will eventually diminish. Improving a process requires adjusting other inputs properly rather than focusing on the same.

When to Use It

The economic theory indicates that after optimal capacity is achieved, additional production units result in fewer increases in output.

Numerous outcomes are subject to a decrease in incremental value.

For example:

  • A group of workers on an assembly line performs quality control, and to increase capacity, they hire another employee. But there is a point where more quality control specialists do not add as much value.
  • In product development, adding employees may not speed up a launch. Instead, other dependencies, onboarding new hires, and internal communications might slow the project.
  • In stagnant economies where production techniques have not changed, output per employee falls. Conversely, progressive economies where technology has been embraced can scale production.

By developing managers and improving technology, one can continue to increase productivity and minimize the effect of diminishing returns.

How to Use It

Most folks know that exponential growth cannot occur perpetually — bottlenecks and constraints exist in any system. Production in this context is affected by four factors: land, capital, labor, and enterprise. They can stimulate economic growth and ultimately limit exponential growth.

Economies of scale emerge when a company impacts all production inputs at once. The output is higher than the inputs; a company outperforms by doubling or tripling its production. When the output is lower than the inputs, returns to scale surface, and a company’s efforts are not realized.

Only one input is changed in diminishing returns, and the others remain constant. For example, a factory manager chooses to increase production by adding an employee. Two employees will double output even when the warehouse space, machines, and technology stay the same. However, adding another body at fifty employees increases production by two percent — constant returns. Then at one hundred employees, without having changed any other input, the manufacturing floor is crowded, and adding another body increases output by less than two percent — diminishing returns. Increasing the number of employees leads to a tipping point for productivity and efficiency.

The math for diminishing returns is as follows: Q= f(L, K)

  • Q signifies the output.
  • Q is dependent on a function (f)
  • Of all variables (L)
  • And fixed inputs (K)

Optimizing the output for one input is possible. However, several other inputs account for production, and focusing on labor alone is inefficient.

    How to Misuse It

    The concept is often mistaken for Marginal Utility, which explains how much satisfaction or pleasure someone receives from increased consumption.

    Next Step

    The applications for the concept are myriad and work across many disciplines. Utilize it to better understand where inefficiencies exist in systems and determine when too much focus has been given to a specific set of inputs.

    Where it Came From

    The world’s first economists, Jacques Turgot, David Ricard, Thomas Robert Malthus, James Anderson, and Johann Heinrich von Thünen, developed the original ideas for the law. The term was first coined and mentioned by Jaquest Turgot in the 1700s.

    In the 1800s, economist David Ricardo and others observed the law while researching the price of wheat and corn in post-war England.

    Classical economists such as Robert Malthus and David Ricardo developed some of the original theories but attributed diminishing returns to a decrease in the quality of the inputs. Their findings proved that additional capital and labor to a given piece of land would generate fewer increases in overall output.

    Thomas Robert Malthus subsequently developed a theory where he modeled population growth against food production and postulated that shortages would inevitably occur.

    What Are Mental Models?

    Mental models are thinking tools that help guide and shape our perceptions of the world. They simplify complexity so we can understand life better, make decisions confidently, and solve problems.

    Deep Dive Into Mental Models

    Deep Dive Into Mental Models

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