The law of diminishing returns
Yvonne Harvey, Contributor

From left: Dunoon Technical High School teacher, Brenton McLean, and students, Nico Tyndale, Terry-Ann Goodridge, Donald Hall, and principal Samuel Thompson. Sanya Smith is in the forefront. Dunoon Technical High School was one of the teams with the best overall project in the Access to Information quiz competition. - Norman Grindley/Deputy Chief Photographer

Good day, readers. The recent lessons on economies and diseconomies of scale taught us that as businesses expand their size of operation, they will experience advantages initially, but ultimately they will be faced with disadvantages.

In the case of a firm, we should also note that as it expands beyond its deal or most efficient size, it will experience diminishing returns. Diminishing returns, therefore, serve as a limit to the expansion of the firm.

This law operates only in the SHORT RUN. The short run is defined as a time period during which there is at least ONE FIXED FACTOR of production. If demand and prices rise, therefore, the firm can only increase output by increasing the variable factors. A fixed factor is a factor of production that cannot be changed or varied in the short run and a variable factor is one that can be changed or varied.

Law of diminishing returns

The law of diminishing returns, also known as the law of variable proportions and the law of diminishing marginal product, states that as successive units of variable factor are added in equal amounts to a fixed factor, the marginal or extra product for each additional unit of the variable factor will eventually decline or fail.

The initial growth of the firm will result in increasing returns. Average costs will fall and profits will rise. However, output will reach a maximum at some point. Further expansion of the firm will cause diminishing returns to operate. Average costs will rise and profits will fall.

To make it clear what actually happens, consider a car tyre without air. This would correspond to the fixed factor of production. The air would correspond to the variable factor of production. As you begin to pump air into the tyre, the tyre will inflate at a fast rate. However, if you continue pumping air into the tyre, after a while, it will inflate at a slower and slower rate. This occurs because the fixed factor (the tyre) is overworked. The same principle applies to a growing business.

It is important to note the following:

1. The law refers to amounts of physical product and not to the value of the output.

2. It assumes that there is no technological change.

3. The law may be applied to all factors of production.

4. Diminishing returns set in primarily because the factors of production are imperfect substitutes for each other.

Notice that the marginal output (the addition to the total output) INCREASES up to the employment of the third unit of labour and capital. The fourth to sixth units of labour and capital show diminishing returns. If the producer should continue adding the variable factors to the fixed factor, the marginal output would decline until it reaches zero. It reaches zero when the total output does not change (i.e. it is constant). When total output falls, marginal output becomes negative.

The diagram above shows the graphical representation of the law of diminishing returns.

Now revise the lesson above, do some additional reading and then answer the following questions:

a) State the law of diminishing returns. (2 marks)

b) Explain TWO reasons why the law operates. (4 marks)

c) Illustrate the law using a table or a graph. (4 marks)

TOTAL: 10 MARKS

Next week our topic will be THE SMALL FIRM. Bye, until then.

Yvonne Harvey teaches at Glenmuir High School.