According to this table, at what stage in the production process do diminishing returns first occur?

Índice Show

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
What is the Law of Diminishing Returns?
Understanding the Point of Diminishing Returns
How to Find the Point of Diminishing Returns?
More Resources

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

What is the Law of Diminishing Returns?

In a production process, as a production factor increases, the amount of total output increases, but will reach an optimal output level before it begins to decrease or diminish. Production factors include inputs such as labor, machine hours, and raw materials.

Assuming a constant level of other production factors, every additional unit of a production factor leads to a greater increase in total output (marginal output) initially. After reaching a certain optimal production level, every additional unit of the production factor will result in a smaller increase in total output with a diminishing marginal output, as the efficiency is limited by the other production factors.

Assuming the production factor considered in the diagram above is labor, the labor force increases from L1 to L2 by the same units as from L2 to L3. Yet, the increase in total output units from Y1 to Y2 is much higher than the increase from Y2 to Y3. Without increasing other production factors, the marginal return will eventually decrease to zero, which means the total output cannot be increased anymore by merely putting extra laborers into the production line.

Understanding the Point of Diminishing Returns

Since adding extra units of a production factor is not always as efficient as it is initially, an optimal production level can be determined. It is the point where the marginal return starts to diminish, and it becomes more difficult to increase the output. It is known as the point of diminishing returns.

At such a point, the marginal output is maximized but will decrease if the units of a production factor continue to increase. As the diagram above shows, the point of diminishing return is at L2. Before reaching an L2 number of laborers, putting additional laborers into the production process can efficiently increase the output.

With an L2 number of laborers, the production line achieves its highest efficiency. It is the optimal level of production, as well as the point of diminishing return. Beyond that point, the marginal output starts to decrease, and each additional unit of added labor will result in a smaller increase in output.

In such a case, in order to efficiently allocate its capital after reaching the point of diminishing return, the company should not invest in extra labor but improve other production factors instead – for example, by increasing capacity through adding more machines or building another factory.

How to Find the Point of Diminishing Returns?

The point of diminishing returns refers to the inflection point of a return function or the maximum point of the underlying marginal return function. Thus, it can be identified by taking the second derivative of that return function.

For example, the return function is:

R = -2x3 + 24x2 + 50;

Thus, the first and second derivatives are:

R’ = -6x2 + 48x, and R’’ = -12x + 48;

The inflection point locates where the second derivative equals zero:

-12x + 48 = 0, so x = -48 / (-12) = 4.

Therefore, the point of diminishing returns for the function is at x = 4 with a return of 306 [-2(4)3 + 24(4)2 + 50].

More Resources

CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: