Diminishing returns

by Admin
Updated: June 15, 2018

The importance of understanding when the law of diminishing returns applies and when it does not

The law of diminishing returns states that when stepping something up, the benefit from each step is less than from the previous one. At the top end of the scale it can even turn negative - which is very bad. At the lower end of the scale it can be equal (or as close as makes no difference) so this law is not evident. At the very bottom of the scale it is usually zero.

The law of diminishing returns is more correctly stated as “The law of diminishing marginal returns” because the total return will still increase even if the marginal return (the difference) is small (provided it is still positive).

The four stages

Here are four generalized stages of increasing activity:

  1. Critical level not reached (no gain per unit of investment).
  2. Increased gain directly proportional to investment.
  3. Diminishing marginal returns.
  4. Negative return.

Diminishing returns are usually illustrated using smooth graphs but in many real-world situations exhibit stepped behavior:

Examples

Consider a production environment such as a workshop where it requires at least 3 workers to make a product, e.g. an engine. Suppose you start with one worker:

  1. Current production is zero. Adding a 2nd worker, it is still zero (it takes at least 3 workers to make a product). Until the 3rd worker is added, we don’t have any production at all.
  2. With 3 workers in place, production is at 3 engines per week. Adding a 4th worker increases it to 4, a 5th increases it to 5 etc. All the way until the workshop is starting to get crowded we see a direct relationship of adding one worker to get one more unit of production per week. No diminishing marginal return.
  3. At 8 workers, the workshop is starting to get crowded and efficiency is starting to drop. They are not quite able to produce 8 finished engines per week. It’s more like 7.75. The 8th worker is only contributing ¾ of an engine per week, 25% less of a difference than worker #7 made. A 9th worker is only able to make a difference of half an engine per week, 25% less again than worker #8. Despite total production still increasing, diminishing marginal returns are now in effect.
  4. Once the break-even threshold is crossed (when costs including the additional work exceed the value of any contribution to production), the marginal return becomes negative. In fact, attempting to add a 10th worker creates chaos. No-one can do their job properly and production actually drops from 8.25 to 8 engines per week. The company may invest in increasing the workspace but, either way, total revenue is reduced in the short term.

A similar model can be applied to the consumption of products instead of production, in which case we talk about “The law of diminishing marginal utility.

For example, eating a first piece of chocolate is highly enjoyable but, as you eat more, each successive piece becomes slightly less enjoyable and, beyond a certain point, forcing down more chocolate could lead to a reversal.

Although not often considered, the model does also apply to investment in general.

For example, to invest in some hypothetical rare commodity, you must first have the minimum funds required to enter the market. Then, for a long time, you can keep investing more at 1:1 with no diminishing return. Eventually, you may have bought so much of the supply that the quality begins to decrease.

Break-even point

In terms of consumption/utility, break-even represents satisfaction (e.g. you’ve had enough chocolate).

In terms of production, break-even means no more profit is being made (e.g. an additional worker only produces 25% of a unit when the gross profit per unit is only 25%). But it might still make sense to continue if the requirement is to complete an order. However, it is likely that paying existing workers for overtime will be more cost efficient.

More info

Jacques Turgot (18th century) is thought to have been the first economist to have recognized the law of diminishing marginal returns as it applied to agriculture (adding twice as much fertilizer produces less than twice as much crop yield).

The Law of Diminishing Returns in Agriculture (PDF, 427kB) by P. E. McNall, 1932, has an interesting in-depth analysis in the context of farming.

Classical economists Thomas Robert Malthus and David Ricardo attributed decreasing marginal returns to a decreasing quality of addition units, however, since this is not necessarily true, modern economists generally treat successive units as being identical.

For more information, learning‑theories.com has a nice overview, businesszeal.com has some helpful examples and the nytimes.com talks about diminishing marginal utility.

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