Economics Terms A-Z
Law of Diminishing Marginal Returns
The law of diminishing marginal returns states that as the input of a factor of production increases ceteris paribus, the additional output from the last unit of input decreases. The production of goods and services requires the input of various factors of production. For example, the production of fruit and vegetables requires sufficient land of the appropriate type with water and sunlight; labour and machinery to plant, cultivate and harvest the crop, as well as packaging and people or machines to present the produce for sale. Similarly, the production of a school education requires trained teachers and administrators, books and other learning materials, as well as buildings and/or other space to host the education.
Applied to the first example of producing fruit and vegetables, the law of diminishing marginal returns implies that increasing the input of one factor such as land, while holding the input of the other factors labour and machinery constant, will increase the amount of the fruit and vegetables produced but at a lower rate. That is, each additional square metre of land, for fixed levels of the other factors, will yield a decreasing amount of fruit and vegetables.
Applied to the second example, the first teacher or the first book will add much to the school education service provided, but each subsequent teacher employed, without increasing the availability of learning materials, administrators and physical space, will only expand the education service at a decreasing rate. The law of diminishing marginal returns can be represented graphically in two dimensions with the (total) return R as a concave function of the input i of a single factor of production (while the inputs of other factors are held constant). As more of this single factor of production is employed, for the same unit increases in input Δi, the additional (i.e. marginal) return diminishes ΔR” < ΔR’ < ΔR:
At first glance, the law of diminishing marginal returns might seem to contradict the concept of economies of scale whereby increasing inputs should generate increasing, not diminishing, returns. Note however that the law of diminishing marginal returns relates specifically to varying the input of a single factor of production while holding all other factors constant. As such, it implies that different factors of production are not perfect substitutes for each other, rather there is a degree of complementarity between input factors. You might be able to bake a larger cake by adding a bit more flour but if you do not also increase the quantities of eggs, sugar and oil the cake is liable to become dry and tasteless!
Its description as a “law” makes the law of diminishing marginal returns sound grand and as indisputable as a law of physics. In fact it can be considered more as an assumption of the theory of production that, as with all assumptions, is open to challenge. Indeed, some economists argue that marginal returns to input factors are increasing at low levels of production. The law of diminishing marginal returns may not apply to all forms of production and therefore it should be treated with caution.
The economist Stanley Brue presents a critical history of the law of diminishing marginal returns in economic thought, highlighting the lack of empirical evidence to support it, in “Retrospectives: The Law of Diminishing Returns” (Journal of Economic Perspectives, 1993).
Good to know
The law of diminishing marginal returns does apply to learning, and in particular to exam preparation: the first hour spent cramming for an exam is generally more productive than subsequent hours. It is important to balance individual learning with dialogue, discussing and questioning the content with others. Experimentation with different input quantities can help you to maximise the returns to your education!
Consumer Surplus and Producer Surplus
Consumer surplus is the gain made by consumers when they purchase an item at the competitive market price rather than the (highest) price that they would have been willing to pay for it. Analogously, producer surplus is the gain made by producers when they sell an item at the market price rather than the (lowest) price that they would also have accepted for it.
An antitrust policy is a law or other government regulation that limits the dominance of large firms and promotes competition in the market.
A market is in equilibrium if at the market price the quantity demanded is equal to the quantity supplied. The price at which the quantity demanded is equal to the quantity supplied is called the equilibrium price or market clearing price and the corresponding quantity is the equilibrium quantity.