Law of diminishing returns

After you have worked through this section of the learning unit, you should be able to:

• describe the law of diminishing returns

The law of diminishing returns plays a central role in determining the cost of production for any kind of business in the short run.

The law of diminishing returns states that in the short run, as more of a variable input is used, while all the other inputs are fixed (kept the same), each additional unit of the variable input will eventually produce less and less additional output. In economics, we say that the marginal product (MP) of the variable input will decline.

To understand the above paragraph, work through the following example:

Our example is based on a small firm called the Blaker Maker, which manufactures garden ornaments from steel. To produce these ornaments, the firm employs the factors of production. Since we are dealing with the short run, we will assume that labour is the only variable input, while the other factors such as machines and factory space are fixed.

The question we then ask is what happens to the output level for Blaker Maker if it increases the amount of labour it uses to produce garden ornaments.

In the first column, we list the number of workers who will be employed; in the second column, we list the total product (TP) or output that the workers produce; and in the third column, we list the marginal product (MP) of each worker. The marginal product is the contribution that an additional worker makes to total production.

Total product and marginal product for Blaker Maker

 Variable input labour Total product (TP) Marginal product (MP) 0 0 --- 1 500 500 2 1 500 1 000 3 3 000 1 500 4 4 000 1 000 5 4 500 500 6 4 750 250 7 4 750 0 8 4 500 -250

The first row tells us that if one worker is employed, the total product (output) of the firm is 500 units and the contribution of the first worker to the total product – which is his marginal product – is 500 units.

The second row indicates that if the second worker is employed, the total product increases to 1 500 units.

What is the marginal product of the second worker?

Think again. We are interested in the contribution the second worker makes to production.

Correct. It is 1 000. By employing the second worker, the total product increases by 1 000 units (1 500 – 5 00 = 1 000).

Think again. We are interested in the contribution the second worker makes to production

By how much does the total product increase if the third worker is employed?

Think again. What is the contribution of the third worker?

Think again. What is the contribution of the third worker?

Correct. It is 1 500. By employing the third worker, the total product increases by 1 500 units (3 000 – 1 500 = 1 500).

If you look at the marginal product of the first three workers, would you say that we are seeing increasing returns or decreasing returns?

Correct. Because there is an increase in each additional worker's contribution, we are looking at increasing returns.

Think again. Because there is an increase in each additional worker's contribution, we are looking at increasing returns.

Why does the marginal product for the first three workers increase?

What we see here are the benefits of specialisation. The first worker has to do everything – fetch the steel rods, cut them, bend them, weld them, paint them, put them in the store room, clean the place, and so on. After the second worker is employed, we see the benefit of the division of labour. While the first worker cuts the iron rods, the second worker might be busy bending them. This benefit of specialisation increases once the third worker is employed.

Note that the higher marginal product of the third worker has nothing to do with the quality of the third worker – we assume that they are equal in all respects. It is because of the division and specialisation that the third worker is more productive.

What happens when the fourth worker is added?

Is there still an increase in the total product or does it decrease when the fourth worker is employed?

• Total product increase
• Total product decrease

Total product increases from 3 000 to 4 000.

What is the marginal product of the fourth worker?

• 500
• 1 000
• 1 500

It is a 1 000 because after adding the fourth worker, total product increases from 3 000 to 4 000.

If you compare the marginal product of the fourth worker to that of the third worker, is it higher or lower?

• Higher
• Lower

It is lower. For the third worker it is 1 500, while for the fourth worker it is 1 000.

Once the fourth worker is added, the total product increases by 1 000 and the marginal product of the fourth worker is 1 000. This increase in total product, however, is lower compared to the increase when a third worker, whose marginal product is 1 500, is added. What we see here is the start of diminishing marginal returns. Total product increases at a diminishing rate.

This trend continues when the fifth and sixth worker are added. When the fifth worker is added, total product increases from 4 000 to 4 500, and the marginal product of the fifth worker is 500. When the sixth worker is added, total product rises from 4 500 to 4 750, and the marginal product of the sixth worker is 250. It is clear that the marginal product declines as the variable input, in this case labour, increases.

Why does this happen?

The marginal product falls because while the number of workers increases, other inputs such as the machines and space remain fixed. The amount of other inputs available per worker declines and this has an impact on productivity.