The Law of Diminishing Marginal Returns: A Simplified Guide
Economic Concept of Decreasing Marginal Benefit: Description, Illustration, Application in Financial Analysis
Wanna know what happens when you keep adding more stuff but get less back in return? That's the law of diminishing marginal returns for ya! This economic concept explains why adding more of a single input while keeping the others constant, will eventually lead to smaller gains in output.
Take our factory example. When a company has an optimally employed workforce, adding more workers can result in inefficiencies. The factory isn't taking full advantage of those extra hands and minds.
This concept has ties to diminishing marginal utility and contrasts with economies of scale.
Key Points
- At some point, extra inputs won't give you the same increase in output - that's the law of diminishing marginal returns in action.
- Beyond an optimal level, adding larger amounts of a factor of production will lead to reduced per-unit incremental returns.
- A factory operating at its peak, for instance, might see less efficiency when adding more workers.
The Law of Diminishing Marginal Returns: A Deeper Dive
Also known as the "law of diminishing returns," the "principle of diminishing marginal productivity," and the "law of variable proportions," this law tells us that the addition of more of one factor of production - all else being equal - will inevitably yield decreased per-unit incremental returns.
This concept doesn't mean the additional unit decreases total production, but it usually does.
The law of diminishing returns is crucial to economic theory, not just economics itself. Businesses, analysts, and financial loan providers use it to determine if increasing production is beneficial by calculating diminishing marginal returns.
Interesting History
The origins of diminishing returns can be traced back to the agricultural revolution. Initially, increases in land and labor led to substantial harvests, but eventually, the law of diminishing returns kicked in. Economists like Jacques Turgot and Thomas Malthus started discussing this concept during the 18th century[1].
Classical economists, such as David Ricardo and Malthus, attributed decreasing outputs to decreases in input quality. Ricardo contributed to the development of the law, referencing it as the "intensive margin of cultivation." He also noted how additional labor and capital added to a fixed piece of land would generate smaller output increases[3].
Malthus introduced the idea during the construction of his population theory. This theory argued that population grows geometrically while food production increases arithmetically, resulting in a population outpacing its food supply[4]. Malthus' ideas about limited food production stemmed from diminishing returns.
Modern economics, on the other hand, suggests that each "unit" of labor is the same, and diminishing returns occur due to disruptions in the entire production process as extra units of labor are added to a set amount of capital[1].
Enrichment Data:
Notable Contributors
- Jacques Turgot (1727–1781): Turgot is often credited for early discussions on diminishing returns. His work, Reflections on the Formation and Distribution of Wealth, formed the basis for further economic studies[2].
- Thomas Malthus (1766–1834): Malthus expanded upon the law by developing population growth theories centered around diminishing returns[4].
- David Ricardo (1772–1823): Ricardo refined the law by explaining diminishing returns in agricultural production, particularly in relation to rent and land use[1].
- Johann Heinrich von Thünen (1783–1850): Thünen made important contributions to understanding marginal productivity theory, which is closely related to the law of diminishing marginal returns[5].
- Alfred Marshall (1842–1924): Marshall popularized the concept of marginal cost, critical to understanding diminishing returns in modern microeconomics[5].
Each of these contributors played a crucial role in shaping our understanding and application of the law of diminishing marginal returns, which continues to be a fundamental principle of economic theory today.
- In the realm of modern finance and business, analysts often calculate diminishing marginal returns to determine if increasing production would yield profitable benefits.
- The concept of diminishing marginal returns, a fundamental principle in economic theory, is also critical in the decentralized finance (DeFi) space, where optimizing token distribution can ensure the greatest returns.
- Similarly, initial coin offerings (ICOs) may face diminishing returns if extra investment does not lead to proportional growth in user adoption or project development, echoing the law of diminishing marginal returns.
