What are diminishing marginal returns?

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The Law of diminishing marginal returns explained
Diagram of diminishing returns
Difference between diminishing returns and dis-economies of scale
Examples of diminishing returns
Diminishing marginal returns to wealth
The law of diminishing returns in the real world

At a certain point, employing an additional factor of production causes a relatively smaller increase in output.

Diminishing returns occur in the short run when one factor is fixed (e.g. capital)
If the variable factor of production is increased (e.g. labour), there comes a point where it will become less productive and therefore there will eventually be a decreasing marginal and then average product.
This is because, if capital is fixed, extra workers will eventually get in each other’s way as they attempt to increase production. For example, think about the effectiveness of extra workers in a small café. If more workers are employed, production could increase but more and more slowly.
This law only applies in the short run because, in the long run, all factors are variable.

The Law of diminishing marginal returns explained

Assume the wage rate is £10, then an extra worker costs £10.
The Marginal Cost (MC) of a sandwich will be the cost of the worker divided by the number of extra sandwiches that are produced
Therefore as MP increases MC declines and vice versa
Total Product (TP) This is the total output produced by workers
Marginal Product (MP) This is the output produced by an extra worker.

The first worker adds two goods. If a worker costs £20. The MC of those two units is 20/2 = 10.
The 3rd worker adds six goods. The MC of those six units are 20/6 = 3.3
The 5th worker adds an extra ten goods. The MC of these 10 is just 2.
After the 5th worker, diminishing returns sets in, as the MP declines. As extra workers produce less, the MC increases.

Diagram of diminishing returns

In this example, after three workers, diminishing returns sets in.
After employing 4 workers or more – the marginal product (MP) of the worker declines and the marginal cost (MC) starts to rise.

Difference between diminishing returns and dis-economies of scale

Diminishing returns relate to the short run – higher SRAC. Diseconomies of scale is concerned with the long run. Diseconomies of scale occur when increased output leads to a rise in LRAC – e.g. after Q4, we get a rise in LRAC.
At output Q1, we get diminishing returns, shown by SRAC1.
If the factory, increases capital, we can get a different outcome, shown by SRAC2. But, we still get diminishing returns in the short run.

Examples of diminishing returns

Use of chemical fertilisers. A good example of diminishing returns includes the use of chemical fertilisers- a small quantity leads to a big increase in output. However, increasing its use further may lead to declining Marginal Product (MP) as the efficacy of the chemical declines.
Revising into the early hours of the morning. If you revise economics for six hours a day, you will improve your knowledge quite a bit. However, if you continue to revise into the early hours of the morning, the amount that you learn increases by only a small amount because you are tired.
Employing extra workers. A cafe may wish to serve more customers during the busy summer months. However, employing extra workers may be difficult because of a lack of space in the cafe.

Diminishing marginal returns to wealth

Another example of diminishing marginal returns could be with regard to wealth. As your wealth increases, initially, your happiness rises as you are able to buy food to eat and a place to live. But, after a certain level of wealth, gaining more wealth doesn’t lead to any rise in happiness. As the old saying goes “money can’t buy happiness”.

Further reading

Diminishing marginal utility of income and wealth
Marginal Cost

The law of diminishing returns is an economic principle stating that as investment in a particular area increases, the rate of profit from that investment, after a certain point, cannot continue to increase if other variables remain at a constant. As investment continues past that point, the return diminishes progressively.

For example, the law of diminishing returns states that in a production process, adding more workers might initially increase output and eventually creates the optimal output per worker. After that optimal point, however, the efficiency of each worker decreases because other factors -- such as the production technique or the available resources -- remain the same (this is known, more specifically, as the law of diminishing marginal returns). This kind of problem might be addressed by modernizing the production technique using technology.

The law of diminishing returns in the real world

While the law of diminishing returns originated in classic economic theory, it is one of the most widely recognized economic principles outside the economics classroom. Some of the most common examples relate to farming, but the law applies in many other real-world situations that extend beyond production and manufacturing into realms such as marketing and customer relationship management.

A good example is social media marketing endeavors. While it is tempting to think that doubling the budget on a social media marketing campaign will double the returns, the increase could easily lead to a glut on information on a single social media channel, causing the returns to decrease substantially. To address this problem, a marketing department should evaluate and adjust other variables, such as its chosen channels or its approach to social media monitoring and analytics.

To stay competitive in areas from campaign planning to enterprise resource planning, it's also important that organizations establish the point of diminishing returns -- which is when per-unit returns start to drop.

To do this, organizations can define the single resource they plan to increase: the number of agents in a call center, for example. Next, they define the total cost of the desired output. This formula becomes trickier, as the output runs the risk of moving from defined numbers to more amorphous metrics such as customer satisfaction. It's important to define metrics as clearly as possible here.

In this example, the metric might be the service level -- the number of calls an agent answers in an established time period. As you add another agent, the service level may improve because the agents aren't overwhelmed and they don't miss calls. At a certain point, though, the return will drop below its original level, and that last person who was added to the staff becomes the point of diminishing return.