The law of diminishing returns states that as we add more units of a variable input (i.e. labour) to fixed amounts of land and capital, the change in total output will at first rise and then fall.
Diminishing returns to labour occurs when marginal product starts to fall. This means that total output will increase at a decreasing rate when more workers are employed. Eventually a decline in marginal product leads to a fall in average product.
What happens to marginal product is linked directly to the productivity of each extra worker employed. At low levels of labour input the fixed factors of production, land and capital tend to be under-utilised which means that each additional worker will be have plenty of capital to use and, as a result, marginal product may rise.
Beyond a certain point the fixed factors of production become scarcer and new workers will not have as much capital to work with (the capital input becomes diluted among a larger workforce). Indeed, eventually workers may start to get in each other’s way. As a result, the productivity of each additional worker falls.
Evaluation: Criticisms of the Law of Diminishing Returns
The law of diminishing returns lies at the heart of mainstream production and cost theory which continued to dominate textbooks! Underlying the idea is an assumption that a business operates in the short run with fixed factor resources and given, constant technology. This concept may hold true for many small and medium sized businesses that have little access to additional resources in the short-run production process.
However the process of globalisation , and the ability of transnational corporations to source their inputs from more than one economy and engage in rapid transfers of technology and other information, makes the concept of diminishing returns less relevant to the real world of business. In many industries as a business expands, it is more likely to experience increasing returns rather than diminishing returns. After all, why should a multinational business spend huge sums on research and development and investment in new capital machinery and an expanding labour force if a business cannot extract increasing from these extra inputs?
The argument that increasing returns to scale are now a more persuasive feature of the production process across many industries and market has important implications for production costs and in particular the potential for a firm to exploit economies of size and scope. This has important implications for many industries – for example the nature of production in the pharmaceutical market or the returns to scale in the global production of computer games consoles.
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