Understanding the Law of Diminishing Returns The law of diminishing returns is crucial in finance, but what exactly is it? Read on to discover all of the details you need to know.
By Dan Bova
The law of diminishing returns is a concept of economics that every entrepreneur should understand.
Also known as the law of diminishing marginal returns, this law helps entrepreneurs and economists gauge how much additional labor or capital should be invested before it becomes counterproductive.
What is the law of diminishing returns?
Manufacturers strive to increase production while reducing costs, desiring to maximize output. This is what the law of diminishing returns is used for — finding the peak of the marginal product.
This description is written out in this simple formula:
Output = variable inputs + fixed inputs
It's essential to understand this formula to numerically calculate the efficiency or productivity of any operation occurring within a business.
How does the law of diminishing returns work?
This law promises to deliver the best results when considering one or multiple units of input.
This law, as discussed above, uses the effectiveness of variable and fixed inputs to find the peak amount of output.
When you increase the amount of one factor of production while keeping other factors constant, there will come a point where the profit produced per unit of that factor will start to decrease — this is the point of diminishing returns.
This occurs because the fixed factors of production become relatively less efficient at utilizing the additional input. The law of diminishing returns aims to find the peak rate of output increase right before additional inputs yield a decreasing rate of marginal utility.
What's an example of the law of diminishing returns?
Consider the following example to better grasp the law of diminishing returns.
Say your variable factor of production is the number of workers measured in units of labor. Adding additional workers will, up to a point, yield an increasing rate of output.
However, at the point of diminishing returns, each extra unit of labor (every additional factor of production) will yield smaller increases in returns.
Since the wage you pay remains the same, you are increasing your cost of production in a manner inconsistent with your rate of product increases.
What's the difference between diminishing marginal returns and returns to scale?
These two concepts are often thrown around and misunderstood but are crucial to understanding the concept of marginal returns.
Diminishing marginal returns happen when a business increases one singular input while maintaining all other inputs.
The marginal output from that input will always eventually start to decline. This only occurs because that one singular input is affected, eventually decreasing it. That is diminishing marginal returns.
Returns to scale describe the relationship between a proportional increase of all inputs, thus increasing or decreasing the output. If the increase in output is proportional to the increase in inputs, then the business identifies this relationship as "constant returns to scale."
If the output exceeds the input increase, it is "increasing returns to scale." And if the output is less than the input increase, you have "decreasing 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 from that output.
This is because when marginal cost equals marginal revenue, the firm is producing at the point where it is maximizing its profits.
Below optimal results
This is what you would assume: When a business produces below the optimal level of output, it will not be making as much profit as it could be. These are below optimal results, and this is what businesses should be looking to avoid.
Optimal results
A business seeking optimal results should identify where the marginal cost of producing an additional unit of output equals the marginal revenue from that unit.
This is the point where the company is maximizing its profits. Beyond this point, adding more inputs will lead to diminishing marginal productivity and a decrease in profit.
Diminishing marginal productivity
This marginal productivity refers explicitly to decreasing the additional output or productivity that occurs when applying an input while holding all others constant.
At this point, the input increases too much and is, in effect, nullified: The input is oversaturated, and the output no longer increases. Too many workers can cause crowding, too much pesticide can kill crops and too much energy can cause an explosion.
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What is the difference between diminishing vs. negative productivity?
Yet again, these two related yet distinct ideas can help you further your understanding of this law and how to apply it in your specific business situation.
Diminishing productivity occurs, similar to diminishing returns, when one input is changed while the others are fixed. Diminishing productivity, however, refers to the actual input being changed, specifically when it diminishes the output. It has to do with the rate of production results.
Negative productivity occurs when the total output decreases due to increasing inputs.
This can happen for various 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 output. This was due to technological innovations and advancements in machinery.
Consequently, the law of diminishing returns was more emphasized because of its relation to efficiency in the production process.
Many authors and classical economists also developed this law throughout the revolution and beyond. Such names include Jacques Turgot, Thomas Robert Malthus and David Ricardo, who all specialized in economic theory.
This revolution and the form of government America operated under brought about a significant increase in specialization.
While this allowed for the division of labor and even more significant technological advances, this also created issues when managing the inputs and streamlining production to an optimal level.
Related: How the Next Industrial Revolution Will Impact 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 numerous examples to observe when trying to comprehend this economic law.
Social media marketing
Social media campaigns are a great example. Any advertisement desires to get its total product seen and purchased. However, there are only so many effective ways to utilize the tools and maximize their reach with their budget.
The quality of content is one type of input that affects this optimal result of traffic and sales. Any successful ad campaign requires quality advertisements that need time, investment and creation to be effective. So, a company needs to invest in quality advertising content creation.
However, after investing and creating, they notice that the incremental gains from their efforts start to decrease. Despite continuing to invest the same amount of resources, they are not gaining as many likes, shares or comments as initially.
This can be due to several things. The law of diminishing returns helps here by addressing possible factors and inputs.
Various strategies might include:
- Experiment with different content formats, such as videos or live streams, to keep the audience engaged.
- Targeting a new audience segment or expanding 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 most significant 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 result.
Agriculture
Another great and easy way to remember this law is through a farm as an example. This is a constant problem that farmers address to have the most efficient farm to produce the most money possible.
Take, for instance, a farmer who wants to increase their crop yield by adding more fertilizer to their fields. Initially, adding fertilizer will result in a proportional increase in crop yield.
However, at a certain point, adding more fertilizer will not result in a proportional increase in yield; the farmer will start to experience diminishing returns. The farmer needs to experiment with the amount of fertilizer in their fields to have the maximum crop yield.
When the optimal yield has been found for fertilizer use, there are many more things a farmer can experiment with.
They can try the following:
- Conducting regular soil tests to determine the optimal amount of fertilizer needed for their crops.
- Rotating crops to prevent nutrient depletion and maintain soil health.
- Using precision agriculture 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 rarely only one factor that affects factors of production.
What does the law of diminishing returns mean for you?
With this knowledge, you can maximize the efficiency of your business. It's as simple as that.
As a business owner, the law of diminishing returns means that there is a point beyond which investing more resources in a particular area of your business will result in a less proportionate increase in output or revenue. This principle can help calculate profitable business decisions in the long or short run.
With these inputs, you must know how to steward them, which means knowing what lack and excess mean for your situation.
By considering the law of diminishing returns when making business decisions, you can make more informed choices about allocating your resources to optimize your business's profitability and growth.
Check out Entrepreneur's other articles for more information about economic laws and other financial topics.
