What Circumstances Cause a Firm to Experience Diminishing Marginal Returns?

by Daria Kelly Uhlig

The law of diminishing returns, or the law of variable proportions, acknowledges that a firm can combine its resources in different proportions and still produce the same product. At first, each modest increase in resources results in a corresponding increase in production. However, the effect is temporary unless other resources increase as well.

Factors of Production

Although sources of productivity number in the millions, according to Auburn University political scientist Paul M. Johnson, economists group them into four broad categories they refer to as the "factors of production": labor, capital, land and entrepreneurship. These resources are vital for producing goods and services.

Marginal Productivity

Johnson defines marginal productivity as "the increase in the value of output that can be produced by adding in one more unit of the particular input while holding other inputs constant." The inputs to which Johnson refers are factors of production. An increase in any one should correspond to an increase in productivity and thus income.

Diminishing Marginal Returns

A diminishing marginal return occurs when increases in one factor of production while the others remain constant results in increasingly reduced productivity. The Melbourne Business School gives as an example a factory that hires additional workers -- labor -- but makes no changes in capital, land or entrepreneurship. If it continues to hire, at some point each additional worker will produce less output than the worker before him because the resources labor needs will be in short supply. The school notes the difference between diminishing marginal returns and diminishing returns, in which the additional workers actually decrease output.

Circumstances Leading to Diminishing Marginal Returns

An increase in any individual factor of production may cause diminishing marginal returns if the levels of other factors remain steady. An imbalance in resource utilization is the cause. Economists consider it a short-term issue, however, because companies generally are able to make up for the imbalance in time. For example, a firm might expand its manufacturing facility, which is capital, to make up for an increase in hiring that caused diminishing marginal productivity among workers.

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