LAW OF DIMINISHING RETURNS

 

Alice has an acre of land where she grows courgettes. Besides the land, she needs seeds, fertiliser, water and labour to ensure a good growth of courgettes. Alice realises that if she increases the amount of fertiliser, her output of courgettes will increase. However, there will be a point where too much fertiliser will reduce her courgette crop.

At this point, the additional courgette output from additional unit of fertiliser will be smaller than the additional output of courgette from the previous increase in fertiliser. The point at which the yield of courgette is highest after which it starts to decline is the point where the law of diminishing returns has kicked in.

So, what is the law of diminishing returns? At some point, employing an additional factor of production causes a smaller increase in output than expected.

Peter’s Cafe

Diminishing returns happen in the short run when one factor is fixed (eg capital). Take the example of a busy café run by Peter. Peter decides to hire extra workers. As his capital is fixed, he cannot expand the space in the café. Although the extra workers will increase production (number of cups of coffee made in a day), they will jostle into each other’s way as space will be limited. At some stage, the marginal increase in Peter’s income will stop or reduce. All this is true only if considered in the short run as all factors become variable in the long run. Thus, law of diminishing returns applies only in the short run.

Let us assume that each worker’s wage is £10 in Peter’s café. Thus, hiring an extra worker will cost an additional wage of £10. The Marginal cost MC of a cup of coffee will be the cost of the worker divided by the number of extra cups of coffee produced. If Marginal Product MP is the output by the extra worker, as MP increases, MC will decrease. And vice versa. Let Total Product TP be the total output by the workers.

 

 

 

CAFÉ WORKERS	Total cups (TP)	MP	MC
1	5	5	2
2	11	6	1.7
3	18	7	1.4
4	26	8	1.25
5	33	7	1.4
6	38	5	2

 

We can see that, at the addition of the fifth employee, diminishing returns set in. This is because as extra employees produce less, MC increases.

A very relatable example for students would be the amount of revision hours they put in for studying for an exam. If they study for three hours a day, they will improve their knowledge considerably. If they study for six to seven hours a day, they will gain knowledge exceedingly well. However, if they study into the late hours up to early morning, sacrificing their sleep, their gain in knowledge will be hardly noticeable as their exhaustion will not let the brain work to its full capacity.