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The Law of Diminishing Returns

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The Law of Diminishing Returns

Imagine there’s a new startup that builds software solutions for customers. The startup has an office with ten computers and it decided to hire new software developers. It begins by hiring five workers. After a certain period, the demand for their services expand. The startup then decides to hire two more workers. This also is not enough to meet the demand, so the startup continues to hire new workers. However, after a certain period, it realises that the office is getting packed and the workers are confused and can’t work efficiently.

This is when the law of diminishing returns comes in. Instead of the new workers bringing in more output for the startup, they actually cause more cost. The law of diminishing returns states that a company starts experiencing diminishing returns after a certain point. A bit confused? Don’t worry. This explanation will help you learn everything you need to know about the law of diminishing returns.

What is the law of diminishing returns?

Before jumping into the definition of diminishing returns, there are a couple of things you need to bear in mind.

A firm maximises profit when it employs an optimal level of inputs, which is the lowest point of cost for which profit is maximised. Essentially, firms maximise profits by having a balance between their revenues and expenses.

You might think that the more input a firm adds to the production processes, the higher its revenues and profits will be. However, that is not always the case:

No. of workers Total product (TP)Marginal product (MP)
155
2138
32512
43510
5405
6422
738-4
830-8

Table 1. Law of diminishing returns - StudySmarter.

The values in the table above are from a firm that produces chocolate bars in the short run. They start with one worker, but then continually add an extra worker. The values for TP are the number of chocolate bars produced in an hour.

From the first two columns, we can calculate the values for MP.

As the change in the number of workers (quantity) is always zero, the marginal product is just the change in total product.

Now, focusing on the marginal product row, we can see that it rises but then starts to fall. This is what the law of diminishing returns states:

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

While employing more labour (factor of production), there was an increase in the total number of chocolate bars produced. But at the margin, each additional increase in the workforce resulted in a smaller increase in output.

Eventually, hiring more workers resulted in a negative marginal output. This means that the seventh worker was not efficient in the production process. This doesn’t mean that the new workers didn’t have the necessary skills. It simply points out the production process becoming inefficient.

It is important to remember that this law is only applicable in the short run because most of the factors of production are fixed. For example, it’s not easy to increase land and capital in the short term as it takes time, but in the long run, these factors are variable (can easily be changed).

Law of diminishing returns diagram

We can illustrate the law of diminishing marginal returns with a diagram, which is seen in Figure 1 below.

law of diminishing returns illustration studysmarterFigure 1. The law of diminishing returns, StudySmarter Original

When the law begins to operate, we have an increasing slope — the total output per additional unit of input increases. Initially, each new worker brings increasing marginal returns and increasing total product.

The point of maximum returns shows the maximum number of workers that should be hired if both total product and marginal returns are to be maximised.

After this point, marginal returns are on a decreasing function. This is what the law of diminishing returns explains.

Therefore we can say that there are three stages of the law of diminishing returns:

  1. Increase of marginal returns.
  2. Maximum marginal returns.
  3. Diminishing marginal returns.

Characteristics of the Law of diminishing returns

The law of diminishing returns argues that when one product factor is constant, the marginal returns you get from adding a unit of the variable factor will start decreasing at a certain point.

The main characteristics of the law of diminishing returns are:

  1. This law can only be observed in production functions.
  2. There is no technological change: the production process stays the same.
  3. The units of the variable factors are homogenous: an additional worker hired is equally skilled and capable to the other workers.
  4. Occurs in the short run.

Law of diminishing returns: applications and examples

The law of diminishing returns has applications almost in all industries but in some sectors more than others.

Agriculture is one of the primary industries where you can easily observe this law applied. The land is fixed capital, and the more workers one employs, the more inefficient the harvesting process will become. The output produced per additional worker hired to work on the farm will quickly drop.

Extractive industries such as fisheries or mines also have diminished returns in their production process. As more fishermen catch fish, extracting fish from the sea becomes more complex.

Think of a factory that has a fixed space and a fixed number of machinery to work with. It is extremely difficult to change the number of machinery, space, or capital available.

The only factor of production that the factory varies is their labour: the number of workers working in the factory.

Hiring additional workers will contribute to the factory’s total output. Each worker coming in will produce more output by using the machinery and space at hand. However, after a certain point, there will be too many workers and it will become increasingly hard for them to move around. This will result in the workers being confused and incapable of efficiently producing output for the factory. The extra unit of output each new worker brings in will start diminishing until a certain point where it becomes negative.

Why is the Law of diminishing returns important?

The law of diminishing returns helps firms choose the amount of input they should add to their production process. Firms can use this to calculate whether hiring an additional worker benefits the firm or just creates additional costs. This helps the firm choose an optimal combination of labour and capital in the production process. As a result, firms are capable of maximising their profits.

The law of diminishing returns is also essential for population growth. There’s only a fixed amount of land which could fit all of us. Population growth might contribute to increased total output, but there will come the point where the additional work produced by an individual will start decreasing.

Another important task of the law of diminishing returns is pointing out the productivity of labour or capital.

Productivity refers to output per either capital or labour.

The UK has recently experienced a decrease in labour productivity compared to other countries such as the United States. There are many reasons why labour productivity has dropped in the UK. Taking into account the law of diminishing returns, the UK can adjust their policies to help improve labour productivity.

The Law of Diminishing Returns - Key takeaways

  • The law of diminishing returns states that when you have a fixed variable in a production process and add more of the other variable, the total output produced by the other variable will fall.
  • The marginal return of labour is the output generated by having the firm hire an additional worker.
  • The law of diminishing returns can only be observed in production processes.
  • The units of the variable factors must be homogenous— an additional worker hired is equally skilled and capable to other workers.
  • The law of diminishing returns only happens in the short run.
  • The law of diminishing returns is quite important as it helps firms choose the number of inputs they should add to their production process.
  • The law of diminishing returns has applications almost in all industries; however, in some sectors more than others.
  • There are three stages of the law of diminishing returns. It starts by having increasing total output, then the total output becomes constant. Finally, the total output begins to fall.

Frequently Asked Questions about The Law of Diminishing Returns

Think of a factory that has a fixed space and a fixed number of machinery to work with. It is extremely difficult to change the number of machinery, space, or capital available.


The only factor of production that the factory varies is their labour: the number of workers working in the factory. 


Hiring additional workers will contribute to the factory’s total output. Each worker coming in will produce more output by using the machinery and space at hand. However, after a certain point, there will be too many workers and it will become increasingly hard for them to move around. 

The law of diminishing returns states that when you have a fixed variable in a production process and add more of the other variable, the total output produced by the other variable will fall.

The law of diminishing returns helps companies maximise their profit and plan their production ahead.

The three stages of the law of diminishing marginal returns are the increasing of returns, constant returns, and diminishing returns.

Final The Law of Diminishing Returns Quiz

Question

What is an example of the law of diminishing returns?

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Answer

Extraction of fish, chocolate production, a software company, etc.

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Question

What is the law of diminishing returns?

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Answer

The Law of diminishing returns states that when you have a fixed variable in a production process and add more of the other variable, the total output produced by the other variable will fall.

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Question

What is the significance of the law of diminishing returns?


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Answer

It helps companies maximise their profit and plan their production ahead.

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Question

What are the three stages of the law of diminishing returns? 


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Answer

Increasing returns, constant returns, and diminishing returns.

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Question

Where can you observe the law of diminishing returns?

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Answer

In production processes.

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Question

Are inputs homogenous or heterogenous in the law of diminishing returns?

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Answer

Homogenous.

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Question

Can you observe the law of diminishing returns in the long run?

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Answer

No, the law of diminishing returns can only be observed in the short run.

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Question

Why can't you observe the law of diminishing returns in the long run?

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Answer

Because other dynamics will start affecting the production process.

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Question

What is the marginal return of labour?

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Answer

The marginal return of labour is the output generated by having the firm hire an additional worker.

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What does productivity refer to?

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Answer

Productivity refers to output per either capital or labour.

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Question

Why is the law of diminishing returns essential for population growth?

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Answer

There’s only a fixed amount of land which could fit all of us. Population growth might contribute to increased total output, but there will come the point where the additional work produced by an individual will start decreasing.

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Question

How do firms use the law of diminishing returns?

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Answer

Firms can use this to calculate whether hiring an additional worker benefits the firm or just creates additional costs.

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Question

What are some of the most common industries where you can observe the law of diminishing returns?

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Answer

Agriculture and extractive industries.

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Question

What are the conditions of the law of diminishing returns?

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Answer

First and foremost, this law can only be observed in production functions. There’s no technological change: no changes made to the technologies used in the production process. Unit of the variable factors are homogenous— an additional worker hired is equally skilled and capable to other workers. The law of diminishing returns is only applicable in the short run. You can observe this law only in the short run as in the long run; other dynamics occur for which the Law is no longer relevant. And it is essential that the output can be measured. It is very unlikely to observe the Law of diminishing returns in customer services.

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Question

What happens if a firm uses new technologies?

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Answer

You can't observe the law of diminishing returns.

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Can you find the Law of diminishing returns outside the production processes?

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Answer

No, the law of diminishing returns only applies to production processes.

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Question

What is an optimal level of inputs?

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Answer

The lowest point of cost for which profit is maximised. 

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Question

Firms maximise profits by having a balance between their revenues and ________.


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Answer

expenses

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Question

The more input a firm adds to the production processes, the higher its revenues and profits will be. 

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Answer

False

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Question

When the marginal product results in negative marginal output, it points out the incompetency of the newly employed workers.

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Answer

False

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Question

The law of diminishing returns is applicable only in the _______.

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Answer

short run

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Question

The law of diminishing returns graph shows a(n) __________ slope.

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Answer

increasing

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Question

The _______________ shows the maximum number of workers that should be hired if both total product and marginal returns are to be maximised. 

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Answer

point of maximum returns

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Question

The three stages of the law of diminishing returns:

  1. _________________.
  2. _________________.
  3. Diminishing marginal returns.

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Answer

  1. Increase of marginal returns.
  2. Maximum marginal returns.

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Question

The main characteristics of the law of diminishing returns are:

  1. __________________.
  2. There is no technological change.
  3. ___________________.
  4. Occurs in the short run.

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Answer

  1. This law can only be observed in production functions.
  2. There is no technological change
  3. The units of the variable factors are homogenous
  4. Occurs in the short run.

Show question

Question

Output per either capital or labour is called _________.

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Answer

productivity

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Question

How can the law of diminishing returns help firms?

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Answer

Firms can use this to calculate whether hiring an additional worker benefits the firm or just creates additional costs. This helps the firm choose an optimal combination of labour and capital in the production process, and maximize their profits.  

Show question

Question

What does the increasing slope of the law of diminishing marginal returns graph suggest?

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Answer

It suggests that the total output per additional unit of input increases. 

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Question

What is meant by: "The units of the variable factors are homogenous"?

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Answer

An additional worker hired is equally skilled and capable to the other workers. 

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