The law of diminishing marginal returns states that in any production process, adding one more production unit while keeping the others constant will cause the overall output to decrease. It is also called "the law of increasing costs" because adding one more production unit diminishes the marginal returns, and the average cost of production inevitably increases.
It is typically valid on a short-term basis because over longer periods of time, it is virtually inevitable that other factors of production will also change in one way or another.
The law of diminishing marginal returns states that adding to inputs will eventually lead to a negative impact on outputs. For it to be valid, some assumptions need to be made:
- All the technology involved is constant. Changing the technological tools used in production would change the marginal and average cost and value of a product. This would negate the premises of the law of diminishing returns by changing more than one production variable.
- Outputs must not vary proportionately. Only one input must vary, while others remain constant at all times. This eliminates production situations where some or all inputs vary proportionately to each other.
The stages of diminishing returns:
When all the prerequisites are met, meaning that one input varies while all others stay the same, the law of diminishing returns states that production efficiency will go through three stages:
Stage 1: Increasing returns
Initially, adding to one production variable is likely to improve the output, as the fixed inputs are in abundance compared to the variable one. Therefore, adding more units of the variable factor will use the fixed factors more efficiently and increase production.
Stage 2: Diminishing returns
As more units of the variable factor are added, the overall production will continue to increase. However, during this stage, the total product increases at a continuously decreasing rate. This process culminates with the product reaching its maximum value, meaning that the marginal product becomes zero. Optimum production is set somewhere within this stage. Adding more units of the variable factor after this point will lead to the overall output starting to diminish.
Stage 3: Negative returns
Excessively adding to the variable input after the point of optimum production will eventually lead not only to a decrease in efficiency but even to a negative return of production. The excess in the variable factor now hurts the whole production process.