Saturday, 17 January 2015

Law of Diminishing Returns explained

When you are discussing about the "Law of diminishing marginal utility", you should not be got confused with the "Law of Diminishing Returns".

The law of diminishing returns is used for production and factors of production assessment whereas the law of diminishing utility is used for studying consumer needs and their satisfaction.

According to the law of diminishing returns, additions to a factor of production while other factors keep constant, will eventually result in diminishing returns after reaching a certain point of production.

This is because of the fact that production involves a mixture of all factors in a certain proportion. If anything gets increased out of proportion, it will result in negative performance. This law of diminishing returns is also known as the Law of Diminishing Marginal Returns.

The production will increase upto a certain point only when you go on increasing any factor of production with no corresponding changes in other factors. But, after that point, if you go on increasing the factor further more, then the additional yield or marginal return begins to fall and eventually on reaching a certain point, the marginal returns can be in minus figures.

Illustration of the Law of Diminishing Marginal Returns
Consider a factory employing new labour to increase the production while keeping other factors of production same. Upto some point, the production will increase. After a point is reached, if it goes on recruiting further labour, the efficiency of labourers will fall and the marginal increase in production falls and will begin decreasing the previous level of production. This is illustrated in the chart below.

Number of Labour
Production in MT
Marginal Production in MT
1000 (initial strength)

In the above example, you are able to notice that at labour strength of 1200, the factory is yielding a very good production of 6000 MT. But when you increase the strength to 1300, the marginal falls. When you employed 200 additional labour the increase in production was 1000 tonne. So, 200 labour contributed to an increase of 1000 ie. 500 tonnes per 100 labour. But the next recruitment of another 100 labour yielded only 300 tonnes of additional production. So, marginal return diminished here. Again, when an additional 100 labour was employed making total labour strength to 1400, the marginal return was only 200 tonnes which further more decreased than previous 300 tonnes. At 1500 strength, there is no increase in production at all. Then your manager went on employing further labour carelessly resulting in inefficiency of the existing labour making the production fall to 6300 MT.

The best marginal return you got in above case was by employing only a further labour of 200. After that recruitment, you should stop increasing the labour and concentrate on improving the other factors of production.

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