## The 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

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 as 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 become a decreasing marginal and then average product when it reaches some point. When capital is fixed in an attempt to increase production and extra workers are hired, production will be increased but it will be slow. The law of diminishing returns applies in the short-run because, in the long-run, all factors are varied.

## Illustration

Assuming the wage rate in a given company is fixed at \$10, and an extra worker costs \$10.

The Marginal Cost (MC) of a sandwich will be calculated by dividing the cost of that worker by the number of extra sandwiches produced.

Marginal Product (MP) is the output produced by that extra worker.

Total Produce (TP) is the total output produced by all workers

The first worker has added 2 goods. At the point where a worker costs \$20, the Marginal Cost (MC) of the two units is 20/2=10.

The 3rd worker adds six goods. The marginal cost of the six units is 20/6=3.3.

The fifth worker adds an extra 10 goods. The marginal cost is just 2.

After worker number five, diminishing returns start to set in because Marginal Product (MP) declines. Since extra workers produce less, The Marginal Cost increases.

Other examples of the 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:

A. Marginal Product (MP) declines.

B. Marginal Cost declines.

C. Marginal Revenue increases.

### Solution

Continuous labor input reaches to a level where an extra worker consumes more than he/she produces, thus producing an extra unit becomes more and more expensive.

Describe the phenomenon of diminishing marginal returns.

## Social Media

© 2016 AnalystPrep  |  Our Affiliate Program  |  Terms and Services  |  Privacy Notice

CFA® is a registered trademark of CFA institute.

CFA Institute does not endorse, promote, review, or warrant the accuracy of the products or services offered by prep courses.