Diminishing returns
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In economics, diminishing returns (also called diminishing marginal returns) refers to how the marginal contribution of a factor of production usually decreases as more of the factor is used. According to this relationship, in a production system with fixed and variable inputs (say factory size and labor), beyond some point, each additional unit of the variable input yields smaller and smaller increases in output. Conversely, producing one more unit of output costs more and more in variable inputs.
This concept is also known as the law of diminishing marginal returns, the law of increasing relative cost, or the law of increasing opportunity cost.
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[edit] History
The concept of diminishing returns can be traced back to the concerns of early economists such as Johann Heinrich von Thünen, Turgot, Thomas Malthus and David Ricardo.
[edit] A simple example
Suppose that one kilogram of seed applied to a plot of land of a fixed size produces one ton of crop. You might expect that an additional kilogram of seed would produce an additional ton of output. However, if there are diminishing marginal returns, that additional kilogram will produce less than one additional ton of crop (on the same land, during the same growing season, and with nothing else but the amount of seeds planted changing). For example, the second kilogram of seed may only produce a half ton of extra output. Diminishing marginal returns also implies that a third kilogram of seed will produce an additional crop that is even less than a half ton of additional output. Assume that it is one quarter of a ton.
In economics, the term "marginal" is used to mean on the edge of productivity in a production system. 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 ton for the first kilogram of seeds, a half ton for the second kilogram, and one quarter of a ton for the third kilogram. Thus, the marginal physical product (MPP) of the seed will fall as the total amount of seed planted rises. In this example, the marginal product (or return) equals the extra amount of crop produced divided by the extra amount of seeds planted.
A consequence of diminishing marginal returns is that as total investment increases, the total return on investment as a proportion of the total investment (the average product or return) also decreases. The return from investing the first kilogram is 1 t/kg. The total return when 2 kg of seed 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.
Another example is a factory that has a fixed stock of capital, or tools and machines, and a variable supply of labor. As the firm increases the number of workers, the total output of the firm grows but at an ever-decreasing rate. This is because after a certain point, the factory becomes overcrowded and workers begin to form lines to use the machines. The long-run solution to this problem is to increase the stock of capital, that is, to buy more machines and to build more factories.
[edit] Returns and costs
There is an inverse relationship between returns of inputs and the cost of production. Suppose that a kilogram of seed costs one dollar, and this price does not change; although there are other costs, assume they do not vary with the amount of output and are therefore fixed costs. One kilogram of seeds yields one ton of crop, so the first ton of the crop costs one extra dollar to produce. That is, for the first ton of output, the marginal cost (MC) of the output is $1 per ton. If there are no other changes, then if the second kilogram of seeds applied to land produces only half the output of the first, the MC equals $1 per half ton of output, or $2 per ton. Similarly, if the 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 rising average costs. In this numerical example, average cost rises from $1 for 1 ton to $2 for 1.5 tons to $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 the extra amount of crop produced, while average cost is the total amount of money spent on seeds divided by the total amount of crop produced.
Cost can also be measured in terms of opportunity cost. In this case the law also applies to societies; the opportunity cost of producing a single unit of a good generally increases as a society attempts to produce more of that good. This explains the bowed-out shape of the production possibilities frontier.
[edit] Returns to scale
Note that the marginal returns discussed in this article refer to cases when only one of many inputs is increased (for example, the quantity of seed increases, but the amount of land remains constant). If all inputs are increased in proportion, the result is generally constant or increased output. (Cf. Economies of scale.)
Statement: As a firm in the long-run increases the quantities of all factors employed, all other things being equal, 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 increase less proportionately than input.
[edit] See also
- Accelerating returns
- Learning curve and Experience curve effects
- Diseconomies of scale, does not assume fixed inputs, thus differing from 'diminishing returns'
- Diminishing marginal utility, also not to be mistaken for 'diminishing returns'
- Increasing returns
- Marginal value theorem
- Moore's law
- Opportunity cost
- Tendency of the rate of profit to fall
[edit] References
[edit] External links
[edit] Sources
- Johns, Karl E. & Fair, Ray C. (1999). Principles of Economics (5th ed.). Prentice-Hall. ISBN 0-13-961905-4.
