Understanding the concepts of diminishing marginal returns and returns to scale is crucial for any business looking to optimize production and increase efficiency. In this article, we will take an in-depth look at the differences between these two important economic principles and how they are applied in the real world.
What Are Diminishing Marginal Returns?
The law of diminishing marginal returns states that adding an additional factor of production, while keeping other factors constant, will eventually yield smaller increases in output. In other words, the marginal output gained from each additional unit of input will diminish as that input is continuously increased.
For example a farmer planting seeds in a field will see increased crop output as he plants more seeds per acre. However there comes a point where planting additional seeds starts to produce smaller and smaller gains in total crop yield. This is because other factors like sunlight, soil nutrients, and water become constrained even as more seeds are added.
Diminishing returns occur in the short run when a variable input is increased while other inputs are held fixed. Common examples include hiring more workers for a fixed factory size or adding more tables to a restaurant with limited kitchen capacity
The law of diminishing marginal returns does not state that total output will decline, only that marginal output per unit of input will diminish Production may still be increasing but at a slower rate
What Are Returns to Scale?
Returns to scale refers to how output changes relative to changes in all inputs. There are three types of returns to scale:
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Constant Returns to Scale (CRS) – Output increases by the same proportion as inputs increase. For example, doubling all inputs doubles total output.
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Increasing Returns to Scale (IRS) – Output increases by a greater proportion than inputs increase. Doubling inputs more than doubles output.
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Decreasing Returns to Scale (DRS) – Output increases by a smaller proportion than inputs increase. Doubling inputs less than doubles output.
Returns to scale measure long-run changes as all factors of production are varied. For example, a company could scale production by building a larger factory, acquiring more machinery, hiring more workers, using more materials, etc.
In contrast to diminishing marginal returns, returns to scale looks at proportional changes in all inputs rather than changes in one input while holding others constant.
Key Differences Between the Two Concepts
Now that we have defined both ideas separately, let’s compare some of the key differences between diminishing marginal returns and returns to scale:
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Time Horizon – Diminishing returns are a short-run concept, while returns to scale focus on long-run production changes.
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Inputs Changed – Diminishing returns look at increasing a single variable input. Returns to scale involve changing fixed and variable inputs.
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Optimal Production – Diminishing returns indicate when a production process has gone beyond optimal capacity. Returns to scale show economies or diseconomies of scale.
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Law vs Measurement – Diminishing returns are an economic law predicting lower marginal output. Returns to scale are a measurement of output changes from input changes.
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Micro vs Macro – Diminishing returns apply at the firm level. Returns to scale apply to whole industries or economies.
Real World Examples
Let’s explore some real world examples that demonstrate these concepts:
Diminishing Marginal Returns
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A factory that has operated three shifts with its current workforce wants to increase production. Adding a fourth overnight shift with the same number of workers provides some gains, but not as much as the previous shifts.
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A farmer has 10 acres of land to plant crops. The marginal yield from each additional acre planted declines as total acres go up due to limitations of water, fertilizer, and equipment.
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A tutoring center has been getting good results with a student-to-tutor ratio of 3:1. Taking on more students per tutor still boosts revenue but lowers educational quality per student.
Returns to Scale
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A software company moves from a small to a large office, hires more developers, and buys more powerful servers. As a result, they are able to quadruple the number of applications they can work on at once.
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An appliance manufacturer builds a new factory with specialized assembly lines and machinery. This expands production capacity from 1,000 to 50,000 units per month.
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A chain restaurant opens five new locations in a city by purchasing property, hiring staff, and equipping kitchens. Total customer capacity increases seven-fold.
As you can see, each of these examples illustrate how companies experience different returns to scale as they grow by proportionally increasing all inputs and production capacity.
How Are These Concepts Used?
Understanding diminishing marginal returns vs returns to scale has several practical business applications:
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Helps set optimal production quantities and capacity to balance efficiency and costs.
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Guides hiring decisions and resource allocation to maximize return on investment.
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Provides insights on economies of scale and when expansion will boost profits.
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Indicates how much a production process can be scaled up in the short run vs long run.
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Assists with sensitivity analysis by showing output elasticity from input changes.
While diminishing marginal returns and returns to scale may sound complex at first, the underlying logic is fairly straightforward. Diminishing returns show falling marginal output from variable input increases in the short run. Returns to scale describe proportional long-run output changes from scaling all inputs.
Businesses apply these ideas to properly allocate scarce resources, determine optimal production levels, and identify opportunities for profitable growth through economies of scale. Understanding the unique mechanics and uses of these two economic phenomena is essential for any operation looking to maximize productivity and returns.
Understanding the Law of Diminishing Marginal Returns
The law of diminishing marginal returns is also referred to as the “law of diminishing returns,” the “principle of diminishing marginal productivity,” and the “law of variable proportions.” This law affirms that the addition of a larger amount of one factor of production, ceteris paribus, inevitably yields decreased per-unit incremental returns. The law does not imply that the additional unit decreases total production, which is known as negative returns; however, this is commonly the result.
The law of diminishing marginal returns does not imply that the additional unit decreases total production, but this is usually the result.
The law of diminishing returns is not only a fundamental principle of economics, but it also plays a starring role in production theory. Production theory is the study of the economic process of converting inputs into outputs. Businesses, analysts, and financial loan providers will calculate the diminishing marginal returns to determine if production growth is beneficial.
What Is the Law of Diminishing Marginal Returns?
The law of diminishing marginal returns is a theory in economics that predicts that after some optimal level of capacity is reached, adding an additional factor of production will actually result in smaller increases in output.
For example, a factory employs workers to manufacture its products, and, at some point, the company operates at an optimal level. With all other production factors constant, adding additional workers beyond this optimal level will result in less efficient operations.
The law of diminishing returns is related to the concept of diminishing marginal utility. It can also be contrasted with economies of scale.
- The law of diminishing marginal returns states that adding an additional factor of production results in smaller increases in output.
- After some optimal level of capacity utilization, the addition of any larger amounts of a factor of production will inevitably yield decreased per-unit incremental returns.
- For example, if a factory employs workers to manufacture its products, at some point, the company will operate at an optimal level; with all other production factors constant, adding additional workers beyond this optimal level will result in less efficient operations.
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The Law (or Principle) Of Diminishing Marginal Returns (or Productivity) Explained in One Minute
What are returns to scale?
Returns to scale include the influence on production output when all the input changes in the same way. There are three ways returns to scale can impact the workplace. They include: Constant returns to scale: When input increases, output increases by a proportional amount.
What is the law of diminishing marginal returns?
The law of diminishing marginal returns shows that additional factors of production result in smaller increases in output at a point. Returns to scale measure the level of increase in output relative to the increase in total input. Both the law of diminishing marginal returns and returns to scale measure output as a result of changes in input.
What is difference between reducing marginal returns and reducing returns to scale?
Diminishing marginal returns are an effect of increasing input in the short run while at least one production variable is kept constant, such as labor or capital. Returns to scale are an effect of increasing input in all variables of production in the long run.
When does marginal return increase vs diminishing returns to scale?
In the short run, marginal return (MR) increases with the addition of three workers before diminishing returns for each additional worker begin 1. Increasing returns to scale If all the inputs are increased by a certain proportion, and the output increases by a larger proportion, there are increasing returns to scale.
