What Is The Law Of Diminishing Returns?

A simple graph visualizing the law of diminishing returns.

In finance and economics, the law of diminishing returns is one of the most important concepts, and it basically explains how putting more of something, like workers or materials, into a process does not always equal proportionally bigger outcomes. This law can be seen in action in everything from businesses and farming to even in day-to-day life. By using this law, people and business owners can identify at which point their actions will no longer pay off as much.

To get what the law of diminishing returns means, you need to imagine yourself in a situation where you’re producing something, like baking cookies in a kitchen. You have a fixed amount of equipment, which, in this case, can mean that you have one oven and a fixed counter space. If you gradually raise some inputs, like by adding more bakers, for example, but keep other inputs, like the oven and the cooking space, the same, the increase in the output (how many cookies you produce) will not be proportional.

At first, the use of one additional baker will yield more cookies because one baker will be doing the dough mixing, while the other will be doing the oven work. Having a second baker adds to the production even more, since they can split the existing jobs. However, if you just keep on adding bakers, like a third or a fourth one, to the same small kitchen, it will get cramped. The extra bakers will hit each other or do nothing while waiting for the oven. Therefore, the total cookies produced will not increase as much as before. As it can be seen in this trend, each added input raises the output, but as more and more is added, the increase in the level of output becomes smaller. This, right here, is the law of diminishing returns.

Like we saw earlier, this law comes into effect when one of the inputs, like the bakers, is added while other inputs, like the oven, stay the same. Economists call the fixed inputs "fixed resources" and those you add "variable resources." The output rises at first because the variable resources make the most of the fixed ones. For example, two bakers used the oven much more efficiently than one. But after a point, the fixed resources dictate how much more you can produce. The oven will only take a certain number of cookies to bake at a given time, so there is not a lot that additional bakers can add to this. The point where every additional input creates less than the previous input is the point of diminishing returns. If you keep adding inputs after this point, aggregate output may even decrease, a phase known as negative returns.

This idea started in finance and economics to explain production, especially in agriculture. In the 18th and 19th centuries, thinkers like Thomas Malthus and David Ricardo studied how land, a fixed factor, worked with labor and tools, the variable factors. They noticed that additional labor put into a field produced crops initially, but over time each successive laborer contributed less in terms of food because the land had boundaries to what it could yield. Ricardo's 1817 book formalized this, showing how diminishing returns limited how much food society could yield as populations grew. Nowadays, this law can be applied to any process that has variable and fixed inputs, from factories to cafes.

At the workplace, the law of diminishing returns helps managers decide on how much they should invest in resources. Think of a shoe factory with 10 machines. Hiring more employees speeds up the production at first, as all the machines get used to full capacity. But after reaching a certain number of workers, everyone waits for the same machines, and some workers do nothing. Factory production rises at a slower rate because the machines are the constraint. If the manager keeps hiring, costs will rise faster than the amount of output, taking away from profits. Data from manufacturing studies, like a 2023 report from the Bureau of Labor Statistics, shows that factories often hit diminishing returns when labor increases by 20-30%, assuming that there’s no new equipment added.

The law of diminishing returns applies to activities outside of the business world as well. If you study for an hour or two, you learn a lot, but after, for example, four or five consecutive hours, your brain is exhausted, and every additional hour, you learn less. A 2021 Journal of Educational Psychology study discovered that students learned 50% less per hour after three hours of consecutive study. The same thing applies to exercising; 30 minutes of lifting weights makes you stronger, but after two hours, your body's too fatigued, and additional time doesn't contribute much to adding strength.

This law is not without its constraints, however. It assumes that most fixed inputs remain constant, but in the real world, companies can usually alter those. For instance, a factory might purchase additional machines, or a kitchen might simply just install a second oven, slowing down diminishing returns. The law of diminishing returns also only looks at short-run production, not long-run expansion, where innovation or doing something different makes a difference.