Kara Sears
The law of diminishing returns is a fundamental principle of economics and plays a central role in production theory. It is the concept that, after a certain point, increasing investment in a particular area will not yield a higher rate of profit if other variables remain constant. In other words, there is a point at which adding more inputs will hamper the production process. This principle is applicable to almost every kind of production process, from farming to manufacturing, and even marketing. It is also relevant to everyday scenarios, such as eating a slice of pizza or buying a bicycle. The law of diminishing returns is commonly understood to be subject to constraints such as limited resources and capitalisation, which can cause economic stagnation.
| Characteristics | Values |
|---|---|
| Origin | The law of diminishing returns originated in classical economic theory and can be traced back to the 18th century in the work of Jacques Turgot. |
| Definition | An economic principle stating that as investment in a particular area increases, the rate of profit from that investment, after a certain point, cannot continue to increase if other variables remain constant. |
| Application | The law of diminishing returns has applications in almost all industries, including agriculture, manufacturing, social media marketing, and enterprise resource planning. |
| Factors | The four factors of production are land, labour, capital, and enterprise. |
| Limitations | This law is only applicable in the short run because most factors of production are fixed in the short term. |
| Related Concepts | Diminishing marginal utility, economies of scale, returns to scale, exponential growth, and production theory. |
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What You'll Learn
The law of diminishing marginal returns
The concept can be further explained by considering other theories, such as the concept of exponential growth. Growth will not continue to rise exponentially but is subject to constraints such as limited resources and capitalisation, which can cause economic stagnation. This is reflected in the production possibilities frontier, which shows that the opportunity cost of producing a single unit of a good generally increases as a society attempts to produce more of that good.
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The bowed-out shape of the production possibilities frontier
The bowed shape of the PPF is a visual representation of the law of diminishing returns. When allocating resources, the initial benefits are significant, but as more resources are added, the benefits decrease over time. This results in the outward curve of the PPF. For example, if we consider investing resources in education and healthcare, the initial increase in resources yields substantial gains. However, as we continue to allocate more resources, the benefits gradually diminish.
The PPF is a powerful tool for businesses and economists to evaluate production scenarios and make informed decisions. By manipulating resource variables, businesses can understand how different factors influence production and determine which products to manufacture. Economists can utilize the PPF to assess a country's economic efficiency and growth by analyzing the production of specific goods in relation to others.
The bowed-out shape of the PPF is in stark contrast to a budget constraint, which is typically represented by a straight line. The key difference lies in the slopes of the curves. The slope of a budget line is defined by the price ratio of the goods or services, which remains constant regardless of the quantity purchased. On the other hand, the slope of the PPF represents the societal cost of producing one good relative to another, and it is here that the law of diminishing returns becomes apparent.
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Diminishing marginal utility
The law of diminishing marginal utility is related to the concept of the law of diminishing returns. It predicts that consumers will gain more satisfaction from the first unit of a product they purchase than from additional purchases of the same product. Marginal utility is the incremental increase in utility that results from the consumption of one additional unit. "Utility" is an economic term that's used to represent satisfaction or happiness.
The law of diminishing marginal utility means that the less satisfaction you get from each additional unit, the more of an item you use or consume. For example, the first bite of chocolate tastes better than the second, and so on. The marginal utility might decrease into negative utility because it may become entirely unfavourable to consume another unit of any product. For instance, the fourth slice of pizza might be difficult to eat because you're already full from the first three slices.
The law of diminishing marginal utility can also be applied to businesses. For example, a company might benefit from having three accountants on its staff but hiring an additional person results in a diminished utility due to the minimum benefit gained if there's no real need for a fourth.
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Experience curve effects
The law of diminishing returns is related to the concept of diminishing marginal utility. It is an economic principle that states that as investment in a particular area increases, the rate of profit from that investment, after a certain point, cannot continue to increase if other variables remain constant. This is also referred to as the "law of diminishing returns", the "principle of diminishing marginal productivity", and the "law of variable proportions".
> Cx = C1 * l^(x-1)
Where b is the progress ratio and 1-b = l is the proportion reduction in the unit cost with each doubling in the cumulative production (learning rate).
The phrase "experience curve" was proposed by Bruce D. Henderson, the founder of the Boston Consulting Group (BCG), based on analyses of overall cost behaviour in the 1960s. Henderson and BCG began to emphasize the implications of the experience curve for strategy in 1968. Research by BCG in the 1960s and 70s observed experience curve effects for various industries that ranged from 10% to 25%.
The relationship between experience producing a good and the efficiency of that production was probably first quantified in the industrial setting in 1936 by Theodore Paul Wright, an engineer at Curtiss-Wright in the United States. Wright found that every time total aircraft production doubled, the required labour time for a new aircraft fell by 20%. This has become known as "Wright's law". Studies in other industries have yielded different percentage values (ranging from only a couple of percent up to 30%), but in most cases, the value in each industry was a constant percentage and did not vary at different scales of operation.
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Liebig's law of the minimum
In simpler terms, Liebig's Law suggests that plant growth is limited by the least available nutrient in the soil. This is often illustrated using a barrel, where each stave represents the amount of a different nutrient. If one of the staves is shorter than the others, it will determine the maximum level the 'barrel' can be filled, regardless of the amounts of other nutrients.
Liebig's Law has been applied in crop modelling to explain plant production at the cellular level. By considering the limiting factor, such as a specific nutrient, Liebig's Law can be used to develop crop models compatible with the Law of Diminishing Returns. This approach helps reconcile Liebig's Law with Mitscherlich's Law of Diminishing Returns, which are often seen as conflicting theories of plant mineral nutrition.
For example, in a study on the effects of heterogeneous input distribution on fields, researchers reconciled the two laws by aggregating the effects of heterogeneities in inputs on linear response and plateau models. They assumed that plant growth is controlled by Liebig's Law in its classical version, resulting in crop production functions compatible with the Law of Diminishing Returns.
In another instance, Liebig's Law was applied to model plant production at the cellular level, considering the uneven distribution of a limiting element and its nutritional requirements within plants. The resulting crop models presented diminishing marginal returns, as expected by Mitscherlich's Law.
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