Law of Diminishing Returns

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Definition of Law of Diminishing Returns:

The law of diminishing returns states that as variable inputs are added to a fixed resource, the resulting rate of increase in production will eventually decrease. 

Detailed Explanation:

It is the opening day for Marcia’s Ice Cream Parlor. Marcia is excited to launch her own business. She doesn’t know how many employees she will need, so she doesn’t hire any yet. Marcia worked very hard to make ice cream the night before the opening and hopes she will have enough for the first day. The good news is that Marcia’s ads and publicity have worked, and many customers come to buy ice cream. The unwelcome news is that Marcia is overwhelmed and is unable to handle the volume of traffic. Some people leave rather than wait in a long line. What should she do? Marcia decides she must hire someone as soon as possible. When she does, production more than doubles. She finds that productivity improves because she and her employee can specialize on a specific task - one takes orders, and the other scoops the ice cream. Fewer customers leave because the lines are much shorter. Marcia notices that some customers are returning and are bringing friends! As Marcia’s business grows she spends more time making ice cream and notices that lines are beginning to get long again. Marcia hires a third, and then a fourth employee. Production increases and her profits grow; but unfortunately, the rate of increase is not as great. Marcia notices that each time she hires someone, the average number of cones served per employee decreases. But that is OK because her profits continue to climb. She hires a fifth employee. Suddenly, production drops, the lines increase, and again people start leaving. Marcia can’t figure out why. Perhaps one of her new employees is rude and not very efficient? If so, which one? She observes that all her employees are very polite and work hard. But she also notices that their frustration level has grown because they seem to frequently bump into each other and drop the ice cream. One time a cone landed on a customer’s head! There just isn’t enough room to move around efficiently and safely.

This example illustrates the law of diminishing returns. Marcia’s building is her fixed asset. She is obligated to pay rent for at least another two years, so space cannot be increased to accommodate the increase in business. Employees are the variable input. Initially, productivity increased after hiring her first employee. When employees were added service was improved and output continued to increase. But the rate of increase was less following the hiring of her third and fourth employees. At that point, the law of diminishing returns has been reached. It is important to note that it may still make sense to hire another employee. The improved service and shorter lines may justify the hiring if the marginal revenue continues to exceed the marginal cost. However, a point is eventually reached when a return turns negative. Marcia witnessed this when she had too many employees and they began bumping into each other, and one even dropped a cone on a customer.

The law of diminishing returns is applicable to more than business. If you ever crammed for exams, you understand the law of diminishing returns. When confronted by exams you must allocate your study time. Initially, time spent studying is very productive. You can focus on the major concepts that will most likely be on the exam that need some clarification. This is the period of specialization. As you continue to study, you begin to focus on smaller details. Although productive, understanding these details is not as important as understanding the primary objectives of each lesson. Diminishing returns have set in. You study on through the night. As you approach 2:00 am, fatigue gets the best of you. You can barely maintain your concentration. Everything becomes confusing. You have reached the point where added study time is counterproductive.

Athletes are very familiar with the law of diminishing returns. Generally, athletes can become quite good at a sport with minimal effort by relying on their physical talent. The process of getting to the next level requires much more practice. Golfers are generally able to shoot between 110 and 120 with minimal practice. Shooting less than 100 may require some practice time on the driving range, but the goal is generally reached without much effort. Improving a score from the '90s to the '80s requires more practice and possibly lessons. Shooting in the 70's requires constant practice. In other words, minimal practice is required to drop a score 10 strokes when someone first takes up the game. The diminishing return is quickly reached as the golfer spends more and more hours to improve by fewer and fewer strokes. 

Dig Deeper With These Free Lessons:

Factors of Production – The Required Inputs of Every Business
Marginal Analysis – How Decisions Are Made
Supply – The Producer's Perspective
Output and Profit Maximization