Learn About the Law of Diminishing Returns in Economics: History and Examples

The Law of Diminishing Returns states that when a factor of production is incrementally increased, and all other elements stay the same, the value added is less than the investment made. Examples of factors of production include physical resources like land, labor, and machinery, along with resources like capital and training.

Say for example, an automobile factory decides to double its workforce. More workers on the floor may cause inefficiencies in process. This will lead to diminishing returns.

While a number of different economists have explored the idea of diminishing returns, Thomas Malthus and David Ricardo are commonly believed to have first articulated the theory that lesser-quality inputs would lead to lower-volume outputs. The earliest applications of the Law of Diminishing Returns were to farming, but more contemporary applications include factories as well as industries that see technological advances.

To illustrate how the concept of diminishing returns applies to the broader framework of the economy, let’s consider the popular saying: “Too many cooks in the kitchen.” Think of the kitchen as the company, and the variable factors as cooks, equipment, and ingredients, to name a few.

The baseline of production is that over the course of a shift, one cook can make five plates of lasagna. The kitchen wants to triple lasagna production, so they hire two more cooks. As it turns out, those three cooks can only produce 12 plates of lasagna. Why? Perhaps there’s not enough room in the kitchen for all three cooks to work at the same time. Or, perhaps there’s a shortage of equipment, like the noodle maker, stove, or oven. Adding even more cooks magnifies these problems, causing the total output to go up at an even smaller rate. This is an example of the Law of Diminishing Returns, also called the Law of Diminishing Marginal Returns: with increased investment (cooks), returns increase, but at a decreasing rate.

Now, let’s say the kitchen decides to add yet another cook, far past its optimal setup, and keeps all other production factors the same. Hardly able to accommodate the cooks already in it, the kitchen will struggle to keep up with making plates of lasagna. Eventually, the kitchen’s output will start going down.

This is the Law of Negative Returns—the idea that, with further increased investment, the returns actually start to decrease.

Let’s go back to the beginning of our kitchen example. When the kitchen adds two more cooks, each cook’s ability to make lasagna goes down. However, if we add just one more cook, the kitchen can produce 10 plates of lasagna, with both cooks at full capacity. This illustrates the Law of Increasing Marginal Returns (also known as the Law of Diminishing Costs), which states that as long as all variables are kept constant, there will be an incremental increase in marginal efficiency (i.e., the extra output gained by adding one unit of input, or labor), and a decrease in marginal cost (the extra cost of producing one additional unit of product).

Of course, the Law of Marginal Returns only works up to the point of maximum return. If the more cooks are added, or one of the ovens breaks, the Law of Diminishing Returns comes into effect, and returns will start to decline.

In short, for any business, be it a lasagna kitchen, a farm, or a software company, the factors of production (e.g. number of workers, the amount of fertilizer, or number of computers) can be adjusted to result in output increases. Investing in these variable factors will lead to marginal returns in the production process. However, at a certain point, investment in additional factors of production will yield diminishing and eventually negative returns.

By understanding the concepts behind the Law of Diminishing Returns, managers and CEOs can work toward an optimal equilibrium that maximizes the efficiency of their businesses.

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