Economics (Law of Diminishing Returns)

Law of diminishing returns – a law affirming that to continue after a certain level of performance has been reached will result in a decline in effectiveness
In 1798 the Reverend Thomas Malthus examined the impact of population growth and reached the somewhat gloomy conclusion that population growth would naturally check itself in the form of famine, wars and disease.


He based this view on the idea that populations tended to grew geometrically (assuming couples had two or more children)
2,4,8,16, 32, 64
while the capacity of land to produce food tended to increase arithmetically (the ability to cultivate more land was less rapid)
2,4,6,8,10,12
The inevitable conclusion for him was that the population growth rate outstripped the capacity of land to provide food for the people, ergo starvation and famine. The theory was based upon what has become known as the law of diminishing returns.

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The laws states that as increasing amounts of a factor input such as labour or fertiliser are added to a fixed factor such as land then the marginal product of the input would eventually diminish i.e. the increase in the output of land, the crop yields, would progressively decrease.


All factors of production have a capacity determined by their physical and technological capability. Simply adding more inputs of labour to an area of land will not continually increase the output of land proportionately.
There comes a time when the capacity of the land is reached and diminishing returns sets in. No extra fertiliser or extra labourers can change the physical composition of the soil to increase its fertility. Indeed the diminishing returns suggest additional factor inputs would reduce productivity of the land.


As with all theories and models, their strength can be tested according to the extent to which they enable predictions to be made about the real world. Has the population of the world or regions shown signs of cataclysmic famine? On a global scale one has to conclude not. The weaknesses of Malthus’s analysis were that he assumed a given state of technology. The technological changes that have enabled the development of improved fertiliser and pesticides and more sophisticated machinery and horticultural techniques generally have ensured that agricultural yields has increased dramatically.


The law of diminishing returns is a short run concept. It assumes that there is a fixed factor and that the state of technology is constant. In reality the productivity of the factor of production land and the state of technology has increased.


Nevertheless, perhaps, in the case of rural Zambia where the population is growing at a rate of between 2 and 3% per annum with a doubling rate of every 20-30 years and limited access to the technologies that enable the productivity of land to be expanded, the worsening levels of poverty are omens to some of Malthus’s gloomy predictions being realised.


The `law of diminishing returns’ plays so large a part both in the theory of rent and the theory of population as they are now taught, that we should naturally expect to find it promulgated both by James Anderson, the reputed anticipator of Ricardo, and by Malthus in his Essay on the Principle of Population.
In this expectation, however, we should be disappointed. Anderson, far from teaching the law of diminishing returns, was one of those enthusiastic agriculturists who have a hazy belief that an increase of the labour employed upon the soil will always bring in a proportionate, if not more than a proportionate, increase of returns. Malthus is often supposed by excessively careless readers to have put forward the law of diminishing returns when he said, `The improvement of the barren parts would be a work of time and labour; and it must be evident to those who have the slightest acquaintance with agricultural subjects, that in proportion as cultivation extended, the additions that could yearly be made to the former average produce must be gradually and regularly diminishing,’ but between this and the law of diminishing returns there is nothing in common, except the use of the word diminishing.’ Nothing that has ever passed muster as the law of diminishing returns ever asserted, as Malthus did, that the increases of the whole produce of a country must necessarily diminish. All that the `law` asserts is that under certain circumstances the returns to a given additional quantity of labour must necessarily diminish. Whether the whole ` addition that can yearly be made to the former average produce’ increases or diminishes depends not only on the produce per pair of hands, but also on the number of pairs of hands. In the first edition of the Essay on the Principle of Population I have not been able to find a trace of the law of diminishing returns. As edition succeeded edition it found its way in here and there, but no great importance was ever attributed to it. Curiously enough, in one of the first places where it is incidentally referred to, Malthus is rebuking Anderson for maintaining `that every increase of population tends to increase relative plenty and vice versa.’
This famous law was first written about by a Frenchman, Anne Robert Jacques Turgot and then alluded to by Thomas Malthus in his Essay on the Principle of Population (1798). The law was discussed in England during debates on free trade and the Corn Laws. Sometimes textbooks call it the law of decreasing (marginal) returns or the law of variable proportions.


Imagine a farm growing wheat. There are a number of jobs that need doing at harvest time and these must be done quickly before weather ruins the crop. First the wheat must be cut and gathered, the wheat and chaff must then be separated. The wheat has then to be carted to a barn, weighed, dried out in some instances, and then stored. All the farm machinery needs maintained, the paperwork completed and last but not least breakfast, lunch and dinner prepared. One man working alone will have difficulty doing all these tasks. By dividing the labour there will be gains in productivity (see division of labour).


If a second worker is employed the tasks can be shared. This means that productivity increases. They each become more skilled in the tasks that they specialise in and save time previously wasted by switching between tasks. However both have to stop when a piece of machinery breaks down or one of them stops for lunch. Employing yet another person may once again improve their productivity. The harvest may continue as they take their lunch in rotation for example. But employing a fourth worker might mean productivity begins to fall (diminish). The gains made by employing the 4th are not as great as employing the 3rd worker. Eventually adding more employees might even lead to an overall decrease in production as they become bored with nothing to do and begin to interfere with production. The table below shows what happens as each extra worker is employed. Marginal means the next unit. So the marginal physical product (MPP) is the amount by which production rises when one extra worker is employed. MPP is calculated by measuring the change in total physical production per worker. The average physical product (APP) is simply the total physical product (TPP) divided by the number of workers
Number of workers
Total Physical Product
(TPP)
Marginal Physical Product
(MPP)
Average Physical Product (APP)
1
10
10
10
2
30
30 -10 = 20
15
3
90
90 – 30 = 60
30
4
120
120 -90= 30
30
5
130
130 -120 = 10
26
6
120
120 -130 = -10
20
In the example the factors of production land and capital are constant but the amount of labour is being varied. The marginal physical product, (MPP) increases to start. When the 4th worker is employed the total still increases from 90 to 120 tonnes, but the increase of 30 tonnes is not as great as the previous increase of 60. It as this point that we say the marginal return diminishes.


The diagram and table shows that when the marginal physical product curve reaches its peak and then changes direction downwards that this is the point of diminishing marginal returns. On the total physical product curve diminishing returns do not occur at the peak of the curve (a common mistake), but where the gradient of the curve instead of becoming steeper changes and becomes less steep (known in maths as the point of inflection).


When MPP becomes negative this means that additional workers are causing a reduction in the total production and the TPP curve changes direction downwards.


The relationship between the marginal and average curves is important to understand. Notice that MPP intersects the APP when APP is at its maximum point. The reason is merely a simple mathematical relationship between marginal and averages. Think of a class of students. The average age in the class is 17. If another student comes in the room and they are 18, what will happen to the average? It will of course increase. On the other hand if the student were 16 the average age in the class would fall. So in the graph, as long as the marginal is higher than the average the average curve goes up and when the marginal is below the average. The average falls.


The demonstration of the law above rests on a couple of assumptions. First we assume that each unit of labour is homogenous. That is that each worker has the same skills and works equally hard. Second, all the other factors of production are held fixed in quantity.


The law of diminishing marginal returns has two main applications for IB students.
1. The shape of the short run cost curve is determined by the principles above and,
2. Diminishing marginal returns in agriculture act as a barrier to economic development