Understand the law of diminishing returns

by Ana Lopez

The law of diminishing returns is an economic concept that every businessupdates.org should understand.

Also known as the law of diminishing marginal returns, this law helps entrepreneurs and economists estimate how much additional labor or capital must be invested before it becomes counterproductive.

What is the law of diminishing returns?

Manufacturers strive to increase production while reducing costs, maximizing output. This is what the law of diminishing returns is used for – finding the peak of marginal product.

This description is written out in this simple formula:

Output = variable inputs + fixed inputs

Understanding this formula is essential to numerically calculate the efficiency or productivity of any operation within a company.

How does the law of diminishing returns work?

This law promises to give the best results when considering one or more input units.

This law, as discussed above, uses the effectiveness of variable and fixed inputs to find the peak amount of output.

When you increase the quantity of one factor of production while keeping other factors constant, there will come a point where the profit per unit of that factor will begin to decline – this is the point of diminishing returns.

This happens because the fixed factors of production become relatively less efficient in using the extra input. The law of diminishing returns aims to find the peak rate of output increase just before additional inputs yield diminishing marginal utility.

What is an example of the law of diminishing returns?

To better understand the law of diminishing returns, consider the following example.

Suppose your variable factor of production is the number of workers, measured in units of labor. Adding additional workers will increase output to some extent.

However, in terms of diminishing returns, each additional unit of labor (each additional factor of production) will produce a smaller increase in returns.

Since the wages you pay remain the same, you increase your production costs in a way that is inconsistent with your rate of product increases.

What is the difference between diminishing marginal revenue and returns to scale?

These two concepts are often used and misunderstood, but are crucial to understanding the concept of marginal revenue.

Diminishing marginal revenue occurs when a firm increases a single input while conserving all other inputs.

The marginal output of that input will always start to decrease eventually. This only happens because that one single input is affected, eventually decreasing it. That is diminishing marginal revenue.

Returns to scale describe the relationship between a proportional increase of all inputs, increasing or decreasing output. If the increase in output is proportional to the increase in inputs, the company identifies this relationship as “constant returns to scale.”

If the output is greater than the increase in the input, then there is “increasing return on scale”. And if the output is less than the increase in the input, you have “diminishing returns to scale”.

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What is an optimal result?

The optimal result occurs when the marginal cost of one additional unit produced equals the marginal revenue of that output.

This is because when marginal cost equals marginal revenue, the firm is producing at the point where it maximizes its profit.

Below optimal results

Here’s what you would assume: When a company is producing below the optimum level of output, it won’t make as much profit as it could. These are among the optimal results, and this is what companies should try to avoid.

Optimal result

A firm pursuing optimal outcomes must determine where the marginal cost of producing an additional unit of output equals that unit’s marginal revenue.

This is the point where the company maximizes its profit. Beyond this point, adding more inputs will lead to diminishing marginal productivity and a drop in profits.

Declining marginal productivity

This marginal productivity explicitly refers to reducing the extra output or productivity that occurs when applying an input while holding all others constant.

At this point, the inputs are increasing too much and are effectively nullifying: the inputs are oversaturated and the outputs are no longer increasing. Too many workers can cause crowding, too many pesticides can kill crops, and too much energy can cause an explosion.

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What is the difference between declining vs negative productivity?

Again, these two related yet different ideas can help you further your understanding of this law and how to apply it to your specific business situation.

Diminishing productivity, similar to diminishing returns, occurs when one input is changed while the others are fixed. Diminishing productivity, however, refers to the actual inputs being changed, especially when it reduces outputs. It has to do with the speed of production results.

Negative productivity occurs when total output decreases due to increasing inputs.

This can happen for a variety of reasons, but negative productivity is the opposite of productivity growth and represents a decrease in a producer’s efficiency. Negative productivity means negative returns.

What is the history of the law of diminishing returns?

During the Industrial Revolution (1760-1840), there was a rapid increase in both productivity and production. This was due to technological innovations and advancements in machinery.

Consequently, the law of diminishing returns became more emphasized because of its relationship to efficiency in the production process.

Many authors and classical economists also developed this law during the revolution and afterwards. Such names include Jacques Turgot, Thomas Robert Malthus and David Ricardoall of whom specialized in economic theory.

This revolution and the form of government under which America operated led to a significant increase in specialization.

While this allowed division of labor and enabled even greater technological advancements, it also created difficulties in managing inputs and streamlining production to an optimal level.

Related: How the next industrial revolution will affect our future

What are some use cases for the law of diminishing returns?

So many understood laws and theories come into play here, but there are also countless examples to observe when trying to understand this law of economics.

Social media marketing

Social media campaigns are a great example. Each ad wants to show and buy its total product. However, there are only a limited number of effective ways to use the tools and maximize their reach with their budget.

Content quality is one type of input that influences this optimal result of traffic and sales. Any successful ad campaign requires quality ads that require time, investment and creation to be effective. So, a company should invest in creating quality advertising content.

However, after investing and creating, they find that the incremental benefits of their efforts begin to diminish. Despite continuing to invest the same amount of resources, they are not getting as many likes, shares, or comments as they did initially.

This can have several causes. The law of diminishing returns helps here by addressing possible factors and inputs.

Different strategies can be:

  • Experiment with different content formats, such as videos or live streams, to keep the audience engaged.
  • Target a new audience segment or expand their reach to different platforms, such as Instagram or Twitter.
  • Analyzing their metrics and performance data to identify which aspects of their campaign generate the greatest impact and optimize their efforts in those areas.

The law of diminishing returns can help by considering all inputs, especially the most effective ones, to have a successful campaign by achieving that optimal outcome.

Agriculture

Another great and easy way to remember this law is to take a farm as an example. This is a constant problem that farmers tackle in order to have the most efficient farm to produce as much money as possible.

Take, for example, a farmer who wants to increase his crop yield by adding more fertilizer to his fields. Initially, adding fertilizer will result in a proportional increase in crop yield.

At some point, however, adding more fertilizer will not lead to a commensurate increase in yield; the farmer will begin to experience diminishing yields. The farmer must experiment with the amount of fertilizer applied to his fields to get the maximum crop yield.

Once the optimal yield for fertilizer use has been found, there are many more things a farmer can experiment with.

They can try the following:

  • Conduct regular soil tests to determine the optimal amount of fertilizer needed for their crops.
  • Rotating crops to prevent nutrient depletion and keep the soil healthy.
  • Using precision farming techniques, such as variable rate application, to apply fertilizer more efficiently and effectively.

What is essential to understand is that in both cases you can only find the optimal return through experimentation. There is seldom just one factor influencing factors of production.

What does the law of diminishing returns mean to you?

With this knowledge you can maximize the efficiency of your company. It’s that simple.

As a business owner, the law of diminishing returns means that there is a point where investing more resources in a particular part of your business will result in a less proportional increase in output or income. This principle can help calculate profitable long-term or short-term business decisions.

With this input, you need to know how to manage them, which means knowing what lack and excess mean for your situation.

By taking the law of diminishing returns into account when making business decisions, you can make more informed choices about how to allocate your resources to optimize the profitability and growth of your business.

Checking out Other businessupdates.org Articles for more information on economic laws and other financial topics.

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