Theory Of Production And Cost

The Law of Diminishing Returns

You might have heard of the proverb: ‘Too many cooks spoil the broth’. The law of diminishing returns discusses this in the context of production. What happens when we keep on adding inputs and exceed the quantity required for optimum production? Let’s find out.

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The Law of Variable Proportions

The law of variable proportions is a new name for the law of diminishing returns, a concept of classical economics. But before getting on with the law, there is a need to understand the total product (TP), marginal product (MP) and average product (AP).

  • Total Product: Total product is the total output obtained from the combined efforts of all the factors of production. Further, if we wish to find the effect of one factor of production, say labour, on the total product, we need to keep all the other factors constant. In this case, the total product would vary with the factor kept variable.
  • Marginal Product: The change in the total product when one more unit is added to the variable factor is known as the marginal product.
  • Average Product: Average product is the total product per unit of the variable factor. In other words, it is the ratio of total product to the quantity of variable factor.

The Relationship between Average Product and Marginal Product

  • When there is a rise in the average product due to an increase in the quantity of the variable input, the marginal product is more than the average product.
  • The maximum average product is equal to the marginal product. Simply put, the maximum point of the average product curve is also a point on the marginal product curve, a point where both of these curves intersect.
  • When the average product falls, the marginal product is less than the average product.

The Law of Diminishing Returns

The law of diminishing returns operates in the short run when we can’t change all the factors of production. Further, it studies the change in output by varying the quantity of one input.

Technically, the law states that as we increase the quantity of one input which is combined with other fixed inputs, the marginal physical productivity of the variable input must eventually decline.

In simpler words, the total productivity, for a given state of technology, is bound to increase with an increase in the quantity of a variable input. However, as the quantity of the inputs keeps on increasing, the marginal product rises to a maximum, then starts to decline and eventually becomes negative.

This is because the crowding of inputs eventually leads to a negative impact on the output. Lastly, The law of diminishing returns also comes with some assumptions:

  • We assume the state of technology to be constant. A variable state of technology would impact the marginal and average product. In that case, we would not be able to accurately study the relationship between output and the fixed input.
  • Only one input should be variable. keeping other inputs constant. This law does not apply to cases when all the inputs vary proportionately. In that case, the returns to scale comes to the rescue.
  • The law does not apply to a production scenario where we require specifically fixed proportions of inputs. In such a case, an increase in any input would not have any impact on production, since the marginal product will be equal to zero.
  • We consider only physical inputs and outputs and not economic profitability in monetary terms.

We can divide the behavior of output when varying one input, keeping other inputs fixed in the short run, into three stages.

The law of diminishing returns

Stage I: Increasing Returns

We characterize this stage with the total output increasing at an increasing rate with each additional unit of the variable input. This continues to point A on the TP curve. Further, the MP curve rises to the point X corresponding to the point B on the TP curve, also known as the point of inflexion.

After point B, the TP curve continues to rise but now at a decreasing rate. The MP also starts to fall but is positive. The end of this stage sees the maximum point of the average product, where the AP and MP curves intersect.

We get increasing returns in the first stage because initially, the fixed factors are abundant relative to the variable factor. The introduction of additional units of the variable factor leads to the effective utilisation of the fixed factors. Evidently, production increases at an increasing rate.

For example, if a machine requires four workers for its optimum utilisation, and in the current scenario is two workers are operating the machine, the factor would be underutilised. Addition of another worker would definitely lead to an increase in the output. Further addition of a worker would lead to optimum utilisation and hence production would increase.

Now we cannot divide the fixed factor (here the machine) to suit the availability of the variable factor (here the workers) because generally the fixed factors are indivisible. Indivisibility of a fixed factor means that due to technological requirements, a minimum amount of the factor must be employed whatever the level of output.

Another reason for rising returns is the increase in the efficiency of the variable factor itself. This is because, with a sufficient quantity of variable factor, the introduction of specialisation and division of labour becomes possible which leads to higher productivity.

Stage II: Diminishing Returns

Throughout the stage of diminishing returns, the total product keeps on increasing. However unlike the stage of increasing returns, here the total product increases at a diminishing rate. This happens because the marginal product falls and becomes less than the average product, which also sees a downwards slope.

Thus, this stage is known as the stage of diminishing returns. The end of this stage is marked by the total product attaining its maximum value and the marginal product becoming zero. Further, this stage is very important because the firm will seek to produce in its range.

After the addition of a certain amount of variable inputs which lead to the optimum and efficient utilisation of fixed input, the output starts diminishing. This is because any further addition to the variable factor after the point of efficient utilisation renders the fixed factor inadequate relative to variable factor. Again, this is the reason why the marginal and average product decline at this stage.

In other words, the contribution of extra variable inputs is actually nil. This further means that the fixed indivisible factor is being worked too hard. Another reason for the law of diminishing returns is the lack of availability of a perfect substitute.

In case of the availability of a perfect substitute, an increase in its quantity would have made up for the scarcity of the fixed factor. This, in turn, would have prevented the ineffective utilisation.

Stage III: Negative Returns

The origin of stage 3 starts from the maximum point of the TP curve. In this stage, the TP curve now starts to decline. Moreover, the MP curve becomes negative coupled with a fall in the AP curve.

The excessive addition of variable inputs leads to negative returns at this stage. This is because of the crowding of the variable factors. The variable and fixed factors now start getting into each other’s ways. Effectively, there is no coordination and hence the output falls.

Stage of Operation

A major dilemma in the world of the law of diminishing returns is deciding the stage where a rational producer would look to operate. Let’s examine each of these stages from his perspective.

The stage of negative returns or stage III is probably not a stage of the producer’s choice. This is because the fixed factors here are over utilised. Thus a rational producer would know that he is not having optimum production.

Further, production can be increased by decreasing the number of variable inputs. Effectively, even if the inputs are free of cost, the producer would stop before the advent of stage III.

Stage I or the stage of increasing returns is a better stage, to start with. However, a rational producer would again not operate in this stage. This is because he would know that he is not making efficient utilisation of the fixed inputs. In simpler words, the fixed inputs are underutilised.

Furthermore, the producer would have an opportunity to increase production by employing more variable inputs and hence firing production on all engines. Eventually, even if the fixed factor is free of cost in this stage, a rational producer would continue adding more units of the variable factor.

So now we understand that both stage I and stage III are not viable stages of production. Evidently, they are also known as the stages of economic absurdity or economic non-sense.

This brings us to the conclusion that a rational producer would operate in the second stage of production, where both average and marginal products tend to decline. At which particular point in this stage, the producer decides to produce depends upon the prices of the factors.

Solved Example on Law of Diminishing Returns

Q: What is the behaviour of TP, MP, and AP at stage III?

Ans: At the stage of negative returns, the total product starts to decline. Further, the average product falls with the marginal product becoming negative.

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