Law of Diminishing Marginal Returns

What is the 'Law of Diminishing Marginal Returns'

The law of diminishing marginal returns is a law of economics that states an increasing number of new employees causes the marginal product of another employee to be smaller than the marginal product of the previous employee at some point.

For example, a factory employs workers to manufacture its product. As long as all other factors of production stay the same, at one point, each supplementary worker generates less output than the worker before him. Thus, each worker who follows provides smaller and smaller returns. If the factory continues to add new workers, it eventually becomes so cramped that additional workers hinder the efficiency of other employees, thereby decreasing the factory’s production.

BREAKING DOWN 'Law of Diminishing Marginal Returns'

The law of diminishing marginal returns goes by a number of different names, including law of diminishing returns, principle of diminishing marginal productivity and law of variable proportions. This law affirms that the addition of a larger amount of one factor of production, while all others remain constant, identified by the Latin term “ceteris paribus,” inevitably yields decreased per-unit incremental returns. The law does not imply the addition of the factor decreases total production, otherwise known as negative returns; however, this commonly happens.

Origins

The idea of diminishing returns has ties back to some of the world’s earliest economists including Jacques Turgot, Johann Heinrich von Thünen, Thomas Robert Malthus, David Ricardo and James Steuart.

The first recorded expression of diminishing returns came from Turgot sometime in the mid-1700s. Classical economists, such as Ricardo and Malthus, attribute successive diminishment of output to a decrease in quality of input. Ricardo contributed to the development of the law, referring to it as the "intensive margin of cultivation." He was the first to demonstrate how additional labor and capital to a fixed piece of land would successively generate smaller output increases. Malthus introduced the idea during the construction of his population theory. This theory argues that population grows geometrically while food production increases arithmetically, resulting in a population outgrowing its food supply. Malthus’ ideas about limited food production stem from diminishing returns.

Neoclassical economists take the position that each “unit” of labor is exactly the same, and diminishing returns are caused by a disruption of the entire production process as extra units of labor are added to a set amount of capital.

Production Theory

The law of diminishing returns is not only a fundamental principle of economics but also plays a starring role in production theory. Production theory is the study of the economic process of converting inputs into outputs.