What is the law of diminishing returns?

Law of diminishing returns use cases and examples

The law of diminishing returns originated in classic economic theory. It's one of the most recognized economic principles. The following are some common examples of this concept:

• Social media marketing. While it's tempting to think that doubling a social media marketing campaign's budget will double its returns, the increase could easily lead to a glut of information on a social media channel, causing the returns to decrease. To address this problem, a marketing department should evaluate and adjust other variables, such as the channels it uses and its approach to social media monitoring and analytics.
• Agriculture. Farming is the classic example of this law. Farmers usually have a finite acreage of land on which they can add an infinite number of laborers to increase crop yields. However, there's a point where an additional worker produces less of an increase in crop yields than the last worker added. At this point, the law of diminishing returns has set in and the farm is less efficient than it was before that additional worker was employed.
• Manufacturing. Other production systems follow this same logic. Adding workers past a certain number to a factory assembly line makes it less efficient because the proportional output becomes less than the labor force expansion.
• Enterprise resource planning. In ERP, it's important that organizations establish the point of diminishing returns -- that is the point where per unit returns start to drop. By establishing this point, organizations can set proper expectations internally and with their customers.

The term also has a common meaning colloquially: The more a person uses something, the less value they receive from it. An example of this could be a specific food, where the more of that food a person has, the less enjoyment they have from eating it.

The term might also be used colloquially to describe purchasing a product. For example, a person might see a dramatic increase in quality by buying a $2,000 camera over a $150 one. But that same person might also find less of a dramatic increase in quality between a $2,000 and $4,000 camera -- and even less of an improvement between a $4,000 and an $8,000 camera. In this sense, the law of diminishing returns is used in reference to a more specific form of the term -- diminishing marginal returns.

What is an optimal result?

The optimal result -- sometimes referred to as the optimal level -- is the ideal production rate, where the maximum amount of output per unit of input is possible.

The optimal result is the point in any system of production in which increasing the quantities of one input while holding all other inputs constant will begin to yield progressively smaller results. Once the optimal result is reached, diminishing returns set in, and the only way to maintain previous output gains is to increase the size of the entire system.

The term optimal result reflects the fact that all a system's elements are working at peak efficiency. For example, on a manufacturing line, the optimal result would be the point at which the line is running at peak performance, and adding workers wouldn't increase production efficiency but would lower the profit per worker ratio.

To define the optimal result, an organization must define the resource it plans to increase, such as the number of agents in a call center. Next, it defines the total production cost of the desired total output. This approach gets trickier when the output considered is something that can't be defined using numbers but rather needs more amorphous metrics such as customer satisfaction. It's important to define metrics as clearly as possible.

The following three states are typically related to the optimal result:

• Below optimal. This is when a system is operating under its peak of functionality, producing less than optimal output levels.
• Optimal. This is when a system is operating at its peak functionality and output levels. All elements in the production are at maximum use. An organization operating in this state is maximizing its profits.
• Diminishing marginal productivity. This is when a system is operating beyond its maximized optimal state. An organization operating at this level is diminishing its potential output.

Law of diminishing returns vs. returns to scale

The law of diminishing returns and returns to scale are two related but different concepts.

Law of diminishing returns. The law of diminishing returns refers to increasing one input in a production process while other inputs remain constant. As each new unit of the increasing input is added, the marginal output gets smaller.

For example, if a bakery with one baker and two ovens adds a second baker, it's able to double its daily bread production. However, adding a third baker won't necessarily triple daily production in the short run over the original rate with one baker because the three bakers still only have two ovens. As the variable factor of production increases, the marginal increase in output gets smaller.

Returns to scale. This refers to a proportional increase in all inputs of a production system. Returns to scale are the effect of increasing all production variables in the long run. It's also referred to as economies of scale.

In the bakery example, when the third baker is added, a third oven is installed as well. The baker and oven are additional factors of production that increase the scale of the entire production system and marginal outputs continue increasing at a consistent rate.

Another example of a return to scale would be to revamp a building's HVAC system with a more energy efficient system instead of periodically upgrading or repairing an old system.

Diminishing marginal returns

The law of diminishing marginal returns is a specific form of the law of diminishing returns.

The law of diminishing marginal returns centers around the concept that, beyond a certain point of optimal capacity, the addition of another factor of production will result in smaller and smaller increases in output. Diminishing marginal returns isn't to say that the overall output is less. Output can still increase as the variable factor increases, but by smaller increments.

Imagine a vegetable garden with three workers. Each day they produce nine carrots between them -- or three carrots per worker. When a fourth worker is hired, the group produces 11 carrots or 2.75 carrots per worker. This is an example of diminishing marginal returns. The output increases, but by a marginal factor.

The law of diminishing returns is a broader concept that encompasses the general principle of declining additional returns when input is increased.

Diminishing vs. negative productivity: What's the difference?

Negative productivity or negative returns occur when the output declines as the variable factor is increased. Put another way, negative productivity deals with successively smaller output. For example, negative productivity would be when a new system component is added and total output decreases compared with the previously existing system.

In the gardening example, when the fourth worker is hired, daily output drops from nine carrots to eight. This would be an example of negative productivity because the actual output decreased.

The terms negative productivity and diminishing marginal returns are similar concepts. While diminishing marginal returns describe smaller increases in output with the addition of another factor of production, negative productivity describes a decrease in output with the addition of another factor of production.

History of the law of diminishing returns

Early mentions of the law of diminishing returns were recorded in the mid-1700s. Jacques Turgot was the first economist to articulate what would become the law of diminishing returns in agriculture. He argued that equal quantities of capital and labor applied successively to a given plot of land will yield monotonically increasing outputs up to a certain point, after which production will steadily decrease with each increase in input.

Classical economist David Ricardo referred to the law as the intensive margin of cultivation. He used it to show how additional labor and capital added to a fixed piece of land generates successively smaller increases in output.

Classical economist Thomas Robert Malthus used a variation of the law of diminishing returns in his population theory, stating that food production increases arithmetically while populations grow geometrically, causing a population to outgrow its food supply. Both theorists attributed diminishing returns to decreased input quality.

By contrast, neoclassical economists argue that each unit of labor is the same and that diminishing returns occur because of limitations on the entire production process as additional units of labor are added to a fixed amount of capital. They contend that value comes from the consumer's perception of a product, whereas classical economists argue that value reflects the cost of production.

The law of diminishing returns deals with a business's ability to produce outputs over time and scale up business functions as it does so. Use this free business impact analysis template to measure the effect of changing certain business functions on the business's overall output.