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DIMINISHING MARGINAL RETURNIn economics, diminishing returns (also called diminishing marginal returns) refers to howthe marginal production of a factor of production starts to progressively decrease as the factor isincreased, in contrast to the increase that would otherwise be normally expected. According tothis relationship, in a production system with fixed and variable inputs (say factory size andlabor), each additional unit of the variable input (i.e., man-hours) yields smaller and smallerincreases in outputs, also reducing each workers mean productivity. Conversely, producing onemore unit of output will cost increasingly more (owing to the major amount of variable inputsbeing used, to little effect).This concept is also known as the law of diminishing marginal returns or the law ofincreasing relative cost.Statement of the lawThe law of diminishing returns has been described as one of the most famous laws in all ofeconomics. In fact, the law is central to production theory, one of the two major divisions ofneoclassical microeconomic theory. The law states "that we will get less and less extra outputwhen we add additional doses of an input while holding other inputs fixed. In other words, themarginal product of each unit of input will decline as the amount of that input increases holdingall other inputs constant." Explaining exactly why this law holds true has sometimes provenproblematic.Diminishing returns and diminishing marginal returns are not the same thing. Diminishingmarginal returns means that the MPL curve is falling. The output may be either negative orpositive. Diminishing returns means that the extra labor causes output to fall which means thatthe MPL is negative. In other words the change in output per unit increase in labor is negativeand total output is falling.History
This section requires expansion.The concept of diminishing returns can be traced back to the concerns of early economists suchas Johann Heinrich von Thünen, Turgot, Thomas Malthus and David Ricardo. However,classical economists such as Malthus and Ricardo attributed the successive diminishment ofoutput to the decreasing quality of the inputs. Neoclassical economists assume that each "unit" oflabor is identical = perfectly homogeneous. Diminishing returns are due to the disruption of theentire productive process as additional units of labor are added to a fixed amount of capital.Karl Marx developed a version of the law of diminishing returns in his theory of the tendency ofthe rate of profit to fall, described in Volume III of Capital.ExamplesSuppose that one kilogram of seed applied to a plot of land of a fixed size produces one ton ofcrop. You might expect that an additional kilogram of seed would produce an additional ton ofoutput. However, if there are diminishing marginal returns, that additional kilogram will produceless than one additional ton of crop (ceteris paribus). For example, the second kilogram of seedmay only produce a half ton of extra output. Diminishing marginal returns also implies that athird kilogram of seed will produce an additional crop that is even less than a half ton ofadditional output, say, one quarter of a ton.In economics, the term "marginal" is used to mean on the edge of productivity in a productionsystem. The difference in the investment of seed in these three scenarios is one kilogram —"marginal investment in seed is one kilogram." And the difference in output, the crops, is one tonfor the first kilogram of seeds, a half ton for the second kilogram, and one quarter of a ton for thethird kilogram. Thus, the marginal physical product (MPP) of the seed will fall as the totalamount of seed planted rises. In this example, the marginal product (or return) equals the extraamount of crop produced divided by the extra amount of seeds planted.
A consequence of diminishing marginal returns is that as total investment increases, the totalreturn on investment as a proportion of the total investment (the average product or return)decreases. The return from investing the first kilogram is 1 t/kg. The total return when 2 kg ofseed are invested is 1.5/2 = 0.75 t/kg, while the total return when 3 kg are invested is 1.75/3 =0.58 t/kg.This particular example of Diminishing Marginal Returns in formulaic terms: Where D =Diminished Marginal Return, X = seed in kilograms, and = crop yield in tons gives us:Substituting 3 for X and expanding yields:
Another example is a factory that has a fixed stock of capital, or tools and machines, and avariable supply of labor. As the firm increases the number of workers, the total output of the firmgrows but at an ever-decreasing rate. This is because after a certain point, the factory becomesovercrowded and workers begin to form lines to use the machines. The long-run solution to thisproblem is to increase the stock of capital, that is, to buy more machines and to build morefactories.Returns and costsThere is an inverse relationship between returns of inputs and the cost of production. Supposethat a kilogram of seed costs one dollar, and this price does not change; although there are othercosts, assume they do not vary with the amount of output and are therefore fixed costs. Onekilogram of seeds yields one ton of crop, so the first ton of the crop costs one extra dollar toproduce. That is, for the first ton of output, the marginal cost (MC) of the output is $1 per ton. Ifthere are no other changes, then if the second kilogram of seeds applied to land produces onlyhalf the output of the first, the MC equals $1 per half ton of output, or $2 per ton. Similarly, ifthe third kilogram produces only ¼ ton, then the MC equals $1 per quarter ton, or $4 per ton.Thus, diminishing marginal returns imply increasing marginal costs. This also implies risingaverage costs. In this numerical example, average cost rises from $1 for 1 ton to $2 for 1.5 tonsto $3 for 1.75 tons, or approximately from 1 to 1.3 to 1.7 dollars per ton.In this example, the marginal cost equals the extra amount of money spent on seed divided by theextra amount of crop produced, while average cost is the total amount of money spent on seedsdivided by the total amount of crop produced.Cost can also be measured in terms of opportunity cost. In this case the law also applies tosocieties; the opportunity cost of producing a single unit of a good generally increases as asociety attempts to produce more of that good. This explains the bowed-out shape of theproduction possibilities frontier.
Returns to scaleThe marginal returns discussed refer to cases when only one of many inputs is increased (forexample, the quantity of seed increases, but the amount of land remains constant). If all inputsare increased in proportion, the result is generally constant or increased output.As a firm in the long-run increases the quantities of all factors employed, all other things beingequal, initially the rate of increase in output may be more rapid than the rate of increase in inputs,later output might increase in the same proportion as input, then ultimately, output will increaseless proportionately than input.