The law of diminishing returns
Yvonne Harvey, Contributor

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 ideal or most efficient size, it will experience diminishing returns.

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, 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.

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 fall.

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:

• The law refers to amounts of physical product and not to the value of the output.
• It assumes that there is no technological change.
• The law may be applied to all factors of production.
• Diminishing returns set in primarily because the factors of production are imperfect substitutes for each other.

It is usual to illustrate the law of diminishing returns using land as the fixed factor and labour and capital as the variable factors of production.

Diagram 1 above shows a numerical illustration of the law of diminishing returns. 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 (that is, it is constant). When total output falls, marginal output becomes negative.

Diagram 2

Diagram 2 shows the graphical representation of the law of diminishing returns.

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

(a) Define the term short run. (2 marks)

(b) What is meant by a fixed factor of production? (2 marks)

(c) Explain what happens when a firm is experiencing increasing returns. (2 marks)

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

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

(f) Illustrate the law using a table or a graph. (6 marks)

(g) Why is it that the law can be applied to any factor of production? (2 marks)

TOTAL: 20 marks

Next week, our topic will be the small firm. Bye until then.

Parents having a good time during the Immaculate Home School Association parenting series with guest speaker, Dr Leahcim Semaj, at the Immaculate Conception High School in St Andrew on Wednesday, March 11. - Peta-Gaye Clachar/Staff Photographer

Yvonne Harvey teaches at Glenmuir High School.