Law of Diminishing Marginal Returns

The law of diminishing marginal returns states that the marginal return from an increased input, say labor, will decrease when this input is added continually to a fixed capital base.

Example: Law of Diminishing Marginal Returns

A good example is that of a factory that employs many workers and produces at full capacity. With all factors of production held constant, at one point, each supplementary worker will be able to generate less output compared to the worker before him. Consequently, each worker that comes next will provide smaller and smaller returns. As a result, the factory’s production declines.

With one factor of production fixed, diminishing returns will occur in the short run. When a certain variable factor of production increases, it will become less productive and eventually result in  a decreasing marginal return.  When capital is fixed, hiring extra workers will increase production at a slower rate with every additional worker. The law of diminishing returns applies in the short run because no factor is constant in the long run.

Illustration

Assuming the wage rate in a small fast-food restaurant is fixed. The following table shows the marginal product of labor for the fast-food restaurant, where MP (marginal product of labor) is the number of hamburgers produced per hour.

$$
\begin{array}{l|c|c}
\textbf{Labor} & \textbf{Output} & \textbf{MP} \\
\hline
1 & 10 & 10 \\
2 & 25 & 15 \\
3 & 45 & 20 \\
4 & 55 & 10 \\
5 & 62 & 7 \\
6 & 69 & 4 \\
\end{array}
$$

Here, the input increases with every worker. However, the Marginal Product of Labor (MP) denotes the additional units produced by each worker. The first worker can produce 10 hamburgers per hour. The second worker will add 15 hamburgers because both workers will specialize in one task in particular. The third worker will add an extra 20 hamburgers.

However, the fourth worker will only add 10 more hamburgers. The 5th will add merely 7 units of output per hour. Why so?

It is because the workspace is limited (numbers of ovens, etc.), adding the fourth worker will increase output but will decrease the MP. Candidates might want to visualize this concept by seeing workers “bumping” into each other while undertaking their tasks.

Other examples of diminishing returns can be the use of fertilizers (chemical). A small amount of fertilizer leads to a large increase in output. However, increased use of these fertilizers causes a declining marginal product.

Question

When there occurs a continuous increase in labor input, diminishing returns start to set in because:

1. the output decreases.
2. marginal Product (MP) declines.
3. the cost of an extra worker is higher than the revenue it generates.

Solution

The correct answer is B.

Diminishing returns represent a point at which additions of the input yield progressively smaller increments in output.

A is incorrect. The output does not decrease. It simply increases at a lower rate.

C is incorrect. There is diminishing marginal productivity, but the business does not run at a loss when it hires additional workers. Each new worker is just less productive.