Limited Time Offer: Save 10% on all 2021 and 2022 Premium Study Packages with promo code: BLOG10    Select your Premium Package »

# 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

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.

Featured Study with Us
CFA® Exam and FRM® Exam Prep Platform offered by AnalystPrep

Study Platform

Learn with Us

Subscribe to our newsletter and keep up with the latest and greatest tips for success
Online Tutoring
Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.

Video Lessons

Sergio Torrico
2021-07-23
Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
diana
2021-07-17
So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
Kriti Dhawan
2021-07-16
A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
nikhil kumar
2021-06-28
Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
Marwan
2021-06-22
Great support throughout the course by the team, did not feel neglected
Benjamin anonymous
2021-05-10
I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
Daniel Glyn
2021-03-24
I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
michael walshe
2021-03-18
Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.