The Law of diminishing returns states that if one factor of production is increased while other remain constant, marginal returns will eventually diminish. This law is an important economic concept, as it deals with one of the most difficult issues surrounding production: how can firms use the fewest amount of inputs (factors of production) to create the highest level of output that is possible? The law of diminishing returns also serves as a reminder for firms that there are diminishing returns associated with any increases in production that go beyond the most efficient mix of inputs and outputs.
Economist David Ricardo is credited with coining the term law of diminishing returns. He used the concept to demonstrate how firms could maximize their profits. He argued that firms should continue to add more of one of the inputs into their production process until it reaches a point where any additional input would decrease returns. In other words, at that point, firms should be looking for either a different mix of inputs or an entirely different product.
The law of diminishing returns applies to both short term and long term production processes. In the short term, a firm may be limited by certain environmental factors, such as the availability of a certain input or machine. These environmental factors can cause a firm to reach a point of diminishing returns at a lower rate of production than they would in the long-term. On the other hand, firms can maximize the use of certain inputs over the course of a longer production period, meaning they can reach higher levels of production and greater output with fewer inputs over the long-term.
The law of diminishing returns is best visualized through an example. Say a manufacturing plant is producing 1,000 widgets per hour using 10 workers and 10 machines. If the plant adds 1 additional worker, output may increase to 1,250 widgets per hour, meaning an increase of 250 widgets per hour from the initial investment of an additional worker. However, if the plant adds a second additional worker, the marginal returns may decrease to 1,200 widgets per hour, meaning output only increases by 200 widgets per hour. The Law of diminishing returns states that as additional workers are added, output will increase but the marginal returns from each additional worker will decrease.
In addition to production processes, the law of diminishing returns can also be used to describe demand and supply trends in the market. In a market with low demand and high supply, additional production would lead to further decreases in marginal returns. The law of diminishing returns states that if too much of a single good is supplied, the price of that good will decrease dramatically as its marginal utility (or how much value a consumer could get from an additional unit of that good) decreases.
The law of diminishing returns is a basic concept in many aspects of economics and business. It is an important reminder for firms that attempting to increase returns through an ever-increasing use of inputs may eventually prove unprofitable. Companies should always analyze their resources, inputs, and production methods in order to find the most efficient way to maximize their profit.
