Diminishing returns
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In economics, diminishing returns is the short form of diminishing marginal returns. In a production system, having fixed and variable inputs, keeping the fixed inputs constant, as more of a variable input is applied, each additional unit of input yields less and less additional output. This concept is also known as the law of increasing opportunity cost or the law of diminishing returns.
Although ostensibly purely an economic concept, diminishing marginal returns appears in some form or another in most fields of human endeavour, especially in the fields of physical sciences and engineering. As such, it is probably the best-known economic principle among non-economists.
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[edit] A simple example
Suppose that one kilogram (kg) of seed applied to a plot of land of a fixed size produces one ton of harvestable crop. You might expect that an additional kilogram of seed would produce an additional tonne of output. However, if there are diminishing marginal returns, that additional kilogram will produce less than one additional tonne of harvestable crop (on the same land, during the same growing season, and with nothing else but the amount of seeds planted changing). For example, the second kilogram of seed may only produce a half tonne of extra output. And diminishing marginal returns also implies that a third kilogram of seed will produce an additional crop that is even less than a half tonne of additional output. Assume that it is one quarter of a tonne.
In economics, the term "marginal" is used to mean on the edge of productivity in a production system. The difference in the investment of seed in these three scenarios is one kilogram — "marginal investment in seed is one kilogram". And the difference in output, the crops, is one ton for the first kilogram of seeds, a half tonne for the second kilogram, and one quarter of a tonne for the third kilogram. Thus, the marginal physical product (MPP) of the seed will fall as the total amount of seed planted rises. In this example, the marginal product (or return) equals the extra amount of crop produced divided by the extra amount of seeds planted.
A consequence of diminishing marginal returns is that as total investment increases, the total return on investment as a proportion of the total investment (the average product or return) also decreases. The return from investing the first kilogram is 1 t/kg. The total return when 2 kg of seed are invested is 1.5/2 = 0.75 t/kg, while the total return when 3 kg are invested is 1.75/3 = 0.58 t/kg.
[edit] A law?
The "law" of diminishing marginal returns says that after a possible initial increase in marginal returns, the MPP of an input will fall as the total amount of the input rises (holding all other inputs constant). The "law" is far from universal in its validity, though there are many examples.
For example, most people find that listening to the same piece of music over and over again during a day implies that each additional hearing is less pleasant than the previous one, at least after the initial stage of gaining familiarity with the piece. This is an example of diminishing marginal utility of the piece. (Case & Fair, 1999: pp. 135-137).
The usual argument in favor of diminishing marginal physical returns is in terms of crowding: if you put too many seeds (or too much fertilizer) in the ground, eventually each additional increment pays off less than previous ones.
[edit] Returns and costs
There is an inverse relationship between returns of inputs and the cost of production. Suppose that a kilogram of seed costs one dollar (country of origin is unimportant), and this price does not change; although there are other costs, assume they do not vary with the amount of output and are therefore fixed costs. One kilogram of seeds yields one ton of crop, so the first ton of the crop costs one extra dollar to produce. That is, for the first ton of output, the marginal cost (MC) of the output is $1 per ton. If there are no other changes, then if the second kilogram of seeds applied to land produces only half the output of the first, the MC equals $1 per half ton of output, or $2 per ton. Similarly, if the third kilogram produces only ¼ ton, then the MC equals $1 per quarter ton, or $4 per ton. Thus, diminishing marginal returns imply increasing marginal costs. This also implies rising average costs. In this numerical example, average cost rises from $1 for 1 ton to $2 for 1.5 tons to $3 for 1.75 tons, or approximately from 1 to 1.333 to 1.71 dollars per ton.
In this example, the marginal cost equals the extra amount of money spent on seed divided by the extra amount of crop produced, while average cost is the total amount of money spent on seeds divided by the total amount of crop produced.
Cost can also be measured in terms of opportunity cost.
[edit] Returns to scale
Note that the marginal returns discussed in this article refer to cases when only one of many inputs is increased (for example, the quantity of seed increases, but the amount of land remains constant). If all inputs are increased in proportion, the result is generally constant or increased output. (Cf. Economies of scale.)
[edit] History
The concept of diminishing returns can be traced back to the concerns of early economists such as Johann Heinrich von Thünen, Turgot, Thomas Malthus and David Ricardo.
Malthus and Ricardo, who lived in 19th century England, were worried that land, a factor of production in limited supply, would lead to diminishing returns. In order to increase output from agriculture, farmers would have to farm less fertile land or farm existing land with more intensive production methods. In both cases, the returns from agriculture would diminish over time, causing Malthus and Ricardo to predict population would outstrip the capacity of land to produce, causing a Malthusian catastrophe. (Case & Fair, 1999: 790).
[edit] See also
- Law of Accelerating Returns
- Opportunity cost
- Increasing returns
- Tendency of the rate of profit to fall
[edit] References
- Johns, Karl E. & Fair, Ray C. (1999). Principles of Economics (5th ed.). Prentice-Hall. ISBN 0-13-961905-4.
