THE LAW OF

DIMINISHING RETURNS

DEFINITION

According to George Stigler "As equal increments of one input are added, the inputs of other productive services being held constant, beyond a certain point, the resulting increments of produce will decrease i.e., the marginal product will diminish."

In other words, as additional units of a variable input are combined with a fixed input, at some point the additional output (i.e., marginal product) starts to diminish. This is also known as The Law of Variable Proportions and The Law of Increasing Relative Cost.

ILLUSTRATION OF THE LAW

ScheduleNo. of Units(L)

Total Product Marginal Product

Average Product

Nature of Marginal Returns

1 10 0 10 INCREASING MARGINAL RETURNS

2 25 15 12.5

3 37 12 12.3

DIMNISHING MARGINAL RETURNS

4 47 10 11.8

5 55 8 11

6 60 5 10

7 63 3 9

8 63 0 7.9 NEGATIVE MARGINAL RETURNS

9 62 -1 6.8

Graphical Representation

Stages of Operation

Stage-I (Increasing Return)

In this stage, total product increases at an increasing rate up to a point. This is because the efficiency of the fixed factors increases as additional units of the variable factors are added to it.

In the figure, from the origin to the point F, slope of the total product curve TP is increasing i.e. the curve TP is concave upwards up to the point F, which means that the marginal product MP of labour rises. The point F where the total product stops increasing at an increasing rate and starts increasing at a diminishing rate is called The Point Of Inflection. Corresponding vertically to this point of inflection marginal product of labour is maximum, after which it diminishes. This stage is called the stage of increasing returns because the average product of the variable factor increases throughout this stage . This stage ends at the point where the average product curve reaches its highest point.

Stage-II (Diminishing Return)

 In this stage, total product continues to increase but at a diminishing rate until it reaches its maximum point H where the second stage ends. In this stage both the marginal product and average product of labour are diminishing but are positive. This is because the fixed factor becomes inadequate relative to the quantity of the variable factor. At the end of the second stage, i.e., at point M marginal product of labour is zero which corresponds to the maximum point H of the total product curve TP. This stage is important because the firm will seek to produce in this range.

Stage-Ill (Negative Return)

In stage 3, total product declines and therefore the TP curve slopes downward. As a result, marginal product of labour is negative and the MP curve falls below the X-axis. In this stage the variable factor (labour) is too much relative to the fixed factor.

Causes for Operation of the Law

Causes of Initial Increasing Returns:

The phase of increasing returns starts when the quantity of a fixed factor is abundant relative to the quantity of the variable factor. As more and more units of the variable factor are added to the constant quantity of the fixed factor, it is more intensively and effectively used. This causes the production to increase at a rapid rate. Another reason of increasing returns is that the fixed factor initially taken is indivisible. As more units of the variable factor are employed to work on it, output increases greatly due to fuller and effective utilization of the variable factor.

Causes of Diminishing Returns:

The 2nd phase of the law occurs when the fixed factor becomes inadequate relative to the quantity of the variable factor. As more and more units of a variable factor are employed, the marginal and average product decline. Another reason of diminishing returns in the production function is that the fixed indivisible factor is being worked too hard. It is being used in non -optima! proportion with the variable factor, Mrs. J. Robinson still goes deeper and says that the diminishing returns occur because the factors of production are imperfect substitutes of one another.

Causes of Negative Returns:

The 3rd phases of the law starts when the number of a variable, factor becomes, too excessive relative, to the fixed factors, A producer cannot operate in this stage because total production declines with the employment of additional labor.A rational producer will always seek to produce in stage 2 where MP and AP of the variable factor are diminishing. At which particular point, the producer will decide to produce depends upon the price of the factor he has to pay. The producer will employ the variable factor (say labor) up to the point whe re the marginal product of the labor equals the given wage rate in the labor market

Assumptions of the Law:

The state of technology is assumed be given and unchanged.

The law specially operates in the short run because some factors are fixed and the proportion between factors is disturbed.

Factor units are homgeneous or identical in amount and quality.

The law is based on the possibility of varying the proportions in which the various factors can be combined to produce a product.

Importance and Applicability of the Law of Variable Proportion

• The Law of Variable Proportion has universal applicability in any branch of production. It forms the basis of a number of doctrines in economics. The Malthusian theory of population stems from the fact that food supply does not increase faster than the growth in population because of the operation of the law of diminishing returns in agriculture.

• Ricardo also based his theory of rent on this principle. According to him rent arises because the operation of the law of diminishing return forces the application of additional doses of labour and capital on a piece of land. Similarly the law of diminishing marginal utility and that of diminishing marginal physical productivity in the theory of distribution are also based on this theory.

• The law is of fundamental importance for understanding the problems of underdeveloped countries. In such agricultural economies the pressure of population on land increases with the increase in population. This leads to declining or even zero or negative marginal productivity of workers. This explains the operation of the law of diminishing returns in LDCs in its intensive form. Ragnar Nurkse has suggested ways to make use of these disguisedly unemployed labour by withdrawing them and putting them in those occupations where the marginal productivity is positive.