Diminishing returns, law of

Sometimes also referred to as the law of variable proportions, this "law" is really a generalization economists make about the nature of technology when it is possible to combine the same factors of production in a number of different proportions to make the same product. The law states:

When increasing amounts of one factor of production are employed in production along with a fixed amount of some other production factor, after some point, the resulting increases in output of product become smaller and smaller.

(That is, first the marginal returns to successive small increases in the variable factor of production turn down, and then eventually the overall average returns per unit of the variable input start decreasing.) Since the law assumes that the available quantity of at least one factor of production is fixed at a given level and that technological knowledge does not change during the relevant period, the law of diminishing returns normally translates into a statement about the short-run choice of production possibilities facing a firm (since in the longer run it is virtually always possible for the firm to acquire more of the temporarily "fixed" factor -- building an additional factory building, buying additional land, installing additional machines of the same kind, installing newer and more advanced machinery, and so on.)

A simple example of the workings of the law of diminishing returns comes from gardening. A particular twenty by twenty garden plot will produce a certain number of pounds of tomatoes if the gardener just puts in the recommended number of rows and plants per row, waters them appropriately and keeps the weeds pulled. If the gardener varies this approach by adding a pound of fertilizer to the topsoil, but otherwise does everything the same, he can increase the number of pounds of tomatoes the garden plot yields by quite a bit (notice the amount of land is being held fixed or constant). If he adds two pounds of fertilizer (rather than just one), probably he can get still more tomatoes per season, but the increase in tomatoes harvested by going from one pound to two pounds of fertilizer is probably smaller than the increase he gets by going from zero pounds to one (diminishing marginal returns). Applying three pounds of fertilizer may still increase the harvest, but perhaps by only a very little bit over the yields available using just two pounds. Applying four pounds of fertilizer turns out to be overdoing it -- the garden yields fewer tomatoes than applying only three pounds because the plants begin to suffer damage from root-burn. And five pounds of fertilizer turns out to kill nearly all the plants before they even flower.

Another similar example of diminishing returns in an industrial setting might be a widget factory that features a certain number of square feet of work space and a certain number of machines inside it. Neither the space available nor the number of machines can be added to without a long delay for construction or installation, but it is possible to adjust the amount of labor on short notice by working more shifts and/or taking on some extra workers per shift. Adding extra man-hours of labor will increase the number of widgets produced, but only within limits. After a certain point, such things as worker fatigue, increasing difficulties in supervising the large work force, more frequent breakdowns by over-utilized machinery, or just plain inefficiency due to overcrowding of the work space begin to take their toll. The marginal returns to each successive increment of labor input get smaller and smaller and ultimately turn negative.

The law of diminishing returns is significant because it is part of the basis for economists' expectations that a firm's short-run marginal cost curves will slope upward as the number of units of output increases. And this in turn is an important part of the basis for the law of supply's prediction that the number of units of product that a profit-maximizing firm will wish to sell increases as the price obtainable for that product increases.

[See also: marginal analysis]