law of diminishing returns

What is the law of diminishing returns?

The law of diminishing returns is an economic principle stating that as investment in a particular area increases, the rate of profit from that investment, after a certain point, cannot continue to increase if other variables remain at a constant. As investment continues past that point, the rate of return begins to decrease.

For example, the law states that in a production process, adding workers might initially increase output. However, at a certain point the optimal output per worker will be reached. Beyond that point, each additional worker's efficiency will decrease because other factors of production remain unchanged, such the available resources.

This production process example is known specifically as the law of diminishing marginal returns. It could be addressed by using technology to modernize production techniques.

Law of diminishing returns use cases and examples

The law of diminishing returns originated in classic economic theory. It is one of the most recognized economic principles. The following are some common examples of this concept:

• Social media marketing. A good example of diminishing returns is social media marketing. While it is tempting to think that doubling a social media marketing campaign's budget will double its returns, the increase could easily lead to a glut of information on a social media channel, causing the returns to decrease. To address this problem, a marketing department should evaluate and adjust other variables, such as the channels it uses and its approach to social media monitoring and analytics.
• Agriculture. Farming is the classic example of this law. Farmers usually have a finite acreage of land on which they can add an infinite number of laborers to increase crop yields. However, there is a point where an additional worker produces less of an increase in crop yields than the last worker added. At this point the law of diminishing returns has set in and the farm is less efficient than it was before that additional worker was employed.
• Manufacturing. Other production systems follow this same logic. Adding workers past a certain number to a factory assembly line makes it less efficient because the proportional output becomes less than the labor force expansion.
• Enterprise resource planning (ERP). In ERP, it is important that organizations establish the point of diminishing returns -- that is the point where per unit returns start to drop. By establishing this point, organizations can set proper expectations internally and with their customers.

What is an optimal result?

The optimal result -- sometimes referred to as the optimal level -- is the ideal production rate, where the maximum amount of output per units of input is possible.

The optimal result is the point in any system of production in which increasing the quantities of one input while holding all other inputs constant will begin to yield progressively smaller results. Once the optimal result is reached, diminishing returns set in, and the only way to maintain previous output gains is to increase the size of the entire system.

The term optimal result reflects the fact that all of a system's elements are working at peak efficiency. For example, on a manufacturing line, the optimal result would be the point at which the line is running at peak performance and adding workers would not increase production efficiency but would lower the profit per workers ratio.

To define the optimal result, an organization has to define the resource it plans to increase, such as the number of agents in a call center. Next, it defines the total production cost of the desired total output. This approach gets trickier when the output considered is something that can't be defined using numbers but rather needs more amorphous metrics such as customer satisfaction. It's important to define metrics as clearly as possible.

Law of diminishing returns vs. returns to scale

The law of diminishing returns and returns to scale are two related but different concepts.

Law of diminishing returns. The law of diminishing returns refers to increasing one input in a production process while other inputs remain constant. As each new unit of the increasing input is added, the marginal output gets smaller.

For example, if a bakery with one baker and two ovens adds a second baker, it's able to double its daily bread production. However, adding a third baker won't necessarily triple daily production in the short run over the original rate with one baker because the three bakers still only have two ovens. As the variable factor of production increased, the marginal increase in output got smaller.

Returns to scale. Returns to scale refers to a proportional increase in all inputs of a production system. Returns to scale are the effect of increasing all production variables in the long run. It is also referred to as economies of scale.

In the bakery example, when the third baker is added a third oven would be installed as well. The baker and oven are additional factors of production that increase the scale of the entire production system and marginal outputs continue increasing at a consistent rate.

Another example of a return to scale would be to revamp a building's HVAC system with a more energy efficient system instead of periodically upgrading or repairing an old system.

Diminishing vs. negative productivity: What's the difference

The terms diminishing marginal returns and negative productivity are similar concepts that are marked by some differences.

Diminishing marginal returns is also referred to as diminishing marginal productivity. It refers to a reduction in the efficiency of a production system and the successively smaller output increases that result.

With diminishing marginal returns, the margins of output become smaller, or the same output might be generated but at a higher cost per unit or marginal cost. Diminishing marginal returns is not to say that the overall output is falling. Output can still increase as the variable factor increases, but by smaller increments.

Imagine a vegetable garden with three workers. Each day they produce nine carrots between them or three carrots per worker. When a fourth worker is hired, the group produces 11 carrots or 2.75 carrots per worker. This is an example of diminishing marginal returns. The marginal output increases but by a smaller factor.

Negative productivity or negative returns occurs when the output declines as the variable factor is increased. Put another way, negative productivity deals with successively smaller output. For example, negative productivity would be when a new system component is added and total output decreases compared with the previously existing system.

In the gardening example, when the fourth worker is hired, daily output drops from nine carrots to eight. This would be an example of negative productivity because the actual output decreased.

History of the law of diminishing returns

Early mentions of the law of diminishing returns were recorded in the mid-1700s. Jacques Turgot was the first economist to articulate what would become the law of diminishing returns in agriculture. He argued that equal quantities capital and labor applied successively to a given plot of land will yield monotonically increasing outputs up to a certain point, after which production will steadily decrease with each increase in input.

Classical economist David Ricardo referred to the law as the intensive margin of cultivation. He used it to show how additional labor and capital added to a fixed piece of land generates successively smaller increases in output.

The classical economist Thomas Robert Malthus used a variation of the law of diminishing returns in his population theory, stating that food production increases arithmetically while populations grow geometrically, causing a population to outgrow its food supply. Both theorists attributed diminishing returns to decreased input quality.

By contrast, neoclassical economists argue that each unit of labor is the same and that diminishing returns occur because of limitations on the entire production process as additional units of labor are added to a fixed amount of capital. They contend that value comes from the consumer's perception of a product, whereas classical economists argue that value reflects the cost of production.

The law of diminishing returns deals with a business's ability to produce outputs over time and scale up business functions as it does so. Use this free business impact analysis template to measure the effect of changing certain business functions on the business's overall output.