Consider a hypothetical firm, Acme Clothing, a shop that produces jackets. During the period of the lease, Acme’s capital is its fixed factor of production. Acme’s variable factors of production include things such as labor, cloth, and electricity. In the analysis that follows, we shall simplify by assuming that labor is Acme’s only variable factor of production. The law of diminishing marginal productivity is also known as the law of diminishing marginal returns.
It is unlikely that all the other variables factors of production will remain unchanged over a long period of time, making the law inapplicable in long term scenarios. In some cases, some factors of production, such as land, are limited in nature and can therefore not be increased. Beyond the optimum capital-labor ratio, there would be no effect of an increased labor on the productivity of labor because labor can substitute capital to a limited extent. This leads to an increase in the number of workers to compensate the decrease in capital and capital-labor ratio. What we observe is that the cost increases as the firm produces higher quantities of output.
From Total Production to Total Cost
We assume capital is a fixed factor of production in the short run, so its cost is a fixed cost. This graph shows Acme’s total product curve from Figure 8.1 “Acme Clothing’s Total Product Curve” with the ranges of increasing marginal returns, diminishing marginal returns, and negative marginal returns marked. Acme experiences increasing marginal returns between 0 and 3 units of labor per day, diminishing marginal returns between 3 and 7 units of labor per day, and negative marginal returns beyond the 7th unit of labor.
Why the Law of Diminishing Returns Matters
The field has a limited size, so as more workers are employed, it becomes overcrowded, making it difficult for workers to move around and leading to inefficiencies. If the farmer continues adding workers beyond this point, the extra production gained from each additional worker will continue to decline, demonstrating the Law of Diminishing Returns. Further, examine something such as the Human Development Index, which would presumably continue to rise so long as GDP per capita (in purchasing power parity terms) was increasing. This would be a rational assumption because GDP per capita is a function of HDI.
- The marginal product of the fifth unit of labor, for example, is plotted between 4 and 5 units of labor.
- The range over which marginal products are increasing is called the range of increasing marginal returns.
- Any increase in the variable input results in a decrease in the rate of production.
- Mathematically, the denominator is so small that average total cost is large.
- You could add an unlimited number of workers to your plot and still increase output at a constant or increasing rate.
- However, it will get to a point where increasing the number of chefs will not result in any meaningful increase in pizza production.
This is why the law can also be referred to as the law of increasing costs. For instance, increasing the number of chefs in your pizza joint will be accompanied by an increase in the salary paid to your chefs cumulatively. This would plunge the world into a state of poverty that would effectively keep the global population from further growth.
The factory can employ 9 workers to keep the marginal product at a rising rate. However, it can add as many as 19 workers before noting a fall in the total product. Law of diminishing returns helps mangers to determine the optimum labor required to produce maximum output. In addition, with the help of graph of law of diminishing returns, it becomes easy to analyze capital-labor ratio. If an organization falls in stage I of production, it implies that its capital is underutilized. No, the Law of Diminishing Returns does not mean that total production will decrease by adding more of a resource; it indicates that the rate of output increase will start to diminish beyond a certain point.
Law of Diminishing Returns
At any one time, a firm will be making both short-run and long-run choices. The managers may be planning what to do for the next few weeks and for the next few years. Their decisions over the next few weeks are likely to be short-run choices. Decisions that will affect operations over the next few years may be long-run choices, in which managers can consider changing every aspect of their operations.
Production Function
The law of diminishing returns states that adding more of one factor of production will at some point yield lower per-unit returns. By factors of production, we’re referring to something like capital (think adding machines or computers) or more labor (hiring additional workers). So this definition is saying that if you hold everything else fixed, and you keep adding more and more workers, eventually you just aren’t going to get very much more production out of those workers. Businesses can use this principle to identify the optimal level of input and operational capacity to maximize efficiency and profitability. The graph of marginal product (MP) is initially upward sloping up to diminishing marginal returns implies the third unit of labour, which shows increasing marginal product with an increase in the units of labour. The average product (AP) is calculated by dividing the total product (TP) by the units of labour (L).
By joining the MRP of different workers on the graph, a curve is obtained known as MRP curve. In case, the organization is in stage III; it implies that the organization needs to reduce number of workers. However, stage I and stage III are irrelevant for managers for setting the targets of output. The different values of Qc can be obtained by substituting different values of L in the equation of production function.