Law of Diminishing Returns Explained

When you are discussing the "Law of Diminishing Returns", you should not get confused with the "Law of Diminishing Marginal Utility".

The law of diminishing returns is used in production and in assessing factors of production, whereas the law of diminishing utility is used to study consumer needs and their satisfaction.

Definition of The Law of Diminishing Returns

According to the law of diminishing returns, adding more of a factor of production while other factors remain constant will eventually result in diminishing returns after a certain point of production.

This is because of the fact that production involves a proportional mixture of all factors. If anything gets increased out of proportion, it will yield a negative result. 

This law of "Diminishing Returns" is also known as the Law of Diminishing Marginal Returns.

Production will increase up to a certain point only when you go on increasing any factor of production, with no corresponding changes in other factors. But, after that point, if you go on increasing the factor further, then the additional yield or marginal return begins to fall and eventually, on reaching a certain point, the marginal returns can be negative figures.

Illustration of the Law of Diminishing Marginal Returns

Consider a factory employing new labour to increase production while keeping other factors of production the same. 

Up to some point, the production will increase. After a point is reached, if it goes on recruiting further labour, the efficiency of labourers will drop, and the marginal increase in production will fall. 

Ultimately, even their original level of production can drop. This is illustrated in the chart below.

Number of Labour	Production in MT	Marginal Production in MT
1000 (initial strength)	5000	5000
1200	6000	1000
1300	6500	500
1400	6200	(-)300
1500	5500	(-)700
1600	4800	(-)700

In the example above, you can see that when the labor strength is increased to 1200, the factory produces 6000 MT (marginal increase in production is 1000 MT). When you employ 200 additional laborers, production increases by 1000 tonnes. So, 200 laborers contributed to an increase of 1000, i.e., 500 tonnes per 100 laborers. The next recruitment of another 100 laborers yielded 500 tonnes of additional production. So, marginal return remained the same. 

But when an additional 100 laborers were employed, making the total labor strength 1400, the marginal return fell by 300 tonnes. At 1500 strength, the marginal return even decreased by another 700 MT. Then your manager went on employing further labor carelessly, with some false hopes of increasing the production without touching other factors of production. And, the result was a drop in the initial production of 5000 MT. They could produce only 4800 MT at a labour strength of 1600.

The best marginal return you achieved in the above case came from employing an additional 200 units of labor. After that recruitment, you should stop increasing labor and focus on improving the other factors of production.