Law of Diminishing Returns: Definition & Examples

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Instructor
Kallie Wells
Expert Contributor
Joseph Shinn

Joe has a PhD in Economics from Temple University and has been teaching college-level courses for 10 years.

How does a farmer determine how much fertilizer to use? How many baristas are needed in a cafe? In this lesson, you will learn how the law of diminishing returns impacts expected output per unit of input.

Law of Diminishing Returns Defined

The law of diminishing returns, also referred to as the law of diminishing marginal returns, states that in a production process, as one input variable is increased, there will be a point at which the marginal per unit output will start to decrease, holding all other factors constant. In other words, keeping all other factors constant, the additional output gained by another one unit increase of the input variable will eventually be smaller than the additional output gained by the previous increase in input variable. At that point, the diminishing marginal returns take effect.

A Farmer Example of Diminishing Returns

Consider a corn farmer with one acre of land. In addition to land, other factors include quantity of seeds, fertilizer, water, and labor. Assume the farmer has already decided how much seed, water, and labor he will be using this season. He is still deciding on how much fertilizer to use. As he increases the amount of fertilizer, the output of corn will increase. It may also reach a point where the output actually begins to decrease since too much fertilizer can become poisonous.

The law of diminishing returns states that there will be a point where the additional output of corn gained from one additional unit of fertilizer will be smaller than the additional output of corn from the previous increase in fertilizer. This table shows the output of corn per unit of fertilizer:

As the farmer increases from one to two units of fertilizer, total output increases from 100 to 250 ears of corn. Therefore the marginal, or additional, ears of corn gained from one more unit of fertilizer is 150 (250 - 100). From two to three units of fertilizer, the total output increases from 250 to 425 ears of corn, a 175 marginal increase.

At what point does the law of diminishing returns set in? Look for the point at which the marginal increase is at the highest point and the next marginal increase is less. In this example, that occurs after the farmer adds the third unit of fertilizer. At three units, the marginal output in ears of corn is 175, but when the fourth unit is added, the marginal output drops to 125.

Again, this does not mean the total production starts to decrease. In fact, the total production is still increasing, as shown in the total ears of corn column. Also note that at the sixth unit of fertilizer, the farmer starts to experience negative returns, where the increase in fertilizer actually decreases the total output and the marginal output becomes negative.

A Café Example of Diminishing Returns

We have all been to a café where they consistently seem slammed with customers in the mornings and wonder why they don't schedule more employees for that shift. Assuming the café cannot increase in size to serve the customers, it has to rely on operating at an efficient point given the input factors that can be easily adjusted. In this case, the input factor that can change in the short run is labor.

This chart shows the total cups of coffee served and marginal coffees served as they increase the number of workers. At what point does the law of diminishing returns set in? Does this situation also experience a decrease in returns? If so, at what point and why do you think that occurs?

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Returns from Labor for Pizza

Production of Pizzas
Units of Labor Total Pizzas Produced Marginal Product of Labor
0 0 -
1 10
2 25
3 40
4 50
5 55
6 57

In the table above, fill in the marginal product of each unit of labor and answer the following questions below.

1. How is the marginal product of labor calculated?
2. Define diminishing marginal returns.
3. Based on the table above, over what range of output is diminishing marginal returns being exhibited?
4. For the first few units of labor, the marginal returns of each unit is increasing. While it is common that the marginal product decreases for most units of an input, it is also typical that the first few units of that input exhibit increasing returns. What causes increasing returns for these units?
5. In determining the importance of hiring a worker, which piece of information is more important for a business owner to know? The marginal product of hiring the worker or the average product (total output divided by the total number of workers)?
6. What are some reasons why the marginal product of labor would increase as the amount of labor used increases?

Returns from Labor for an Accounting Firm

Based on the following information, answer the questions below. When an accounting firm employes 10 accountants, 100 tax returns are processed per week. When the firm employees 11 and 12 workers, the number of tax returns processed per week increases to 105 and 109.

1. What is the marginal product of the 11th and 12th accountants?
2. Is the firm experiencing diminishing marginal returns for the 12th accountant hired? Why or why not?

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