The Act of Diminishing Returns - Essay Example

The Law of Diminishing Returns Introduction The field of economics has several laws of which the law of diminishing returns is one of the best known. It is also known as the law of diminishing marginal returns and in the simplest of terms, it states that wherever there are fixed and variable inputs in a production line, after a certain point, the addition of more variable inputs will yield less and less output per unit. While this law may be simple enough in its statement, the theory behind the law is quite complex due to its application to the idea of the economies of scale. To better understand the law itself and the application of the law, it would be useful to look at a few examples as well as the origins of the law. Origins Cannan (1981) says that while the great British economist Malthus has been given a large part of the credit for discovering this law, it was Turgot who actually considered it in its application to the field of agriculture. Turgot writes that: “Where ordinary good cultivation prevails, the annual advances bring in 250 to the hundred, it is more than probable that if the advances were increased by degrees from this point up to that at which they would bring in nothing, each increment would be less and less fruitful (Cannan, 1981, Pg. 74)”. The law of diminishing returns was likened by Turgot to a spring which is forced to stretch due to the load of weights on it. As more and more weights are added to the spring, the relative extension starts decreasing until there comes a point where no further extension can be made to the spring (Cannan, 1981). The ideas given by Turgot can be simplified by using his own agricultural example but giving it a more modern complexion. For instance, given that we know that x amount of seed in one hectare of land would produce 3y of crop, we could assume that doubling the amount of seed would produce 2(3y) of crop i.e. 6y, if everything else remains the same. However, once the amount of seed is doubled, the output crop may not be exactly double and we could end up with a crop which is equal to 4y or 5y. If the amount of seed was further increased to 3x the returning crop amount could be 4.5 y or even less. In this manner, the marginal return from each additional unit of seed would become lesser and lesser until the marginal result would become close to zero. Even though it was Turgot who suggested the ideas behind this law of economics, Malthus popularized the concept with his Essay on the Principle of Population which was published in 1798 and discussed many different economic concepts (Cannan, 1981). Application of the Law Rodda (2001) gives an excellent example of how the law is applied in real world situations such as farming and farm labor. At any farm, there are quite a few activities which require input in the form of human labor. At the time of harvest, many tasks have to be performed in succession and they have to be done quickly in order to ensure that the product is not damaged. For instance, at a wheat farm, wheat needs to be cut, gathered and separated. It may also need to be dried out, weighed and put into sacks for storage or sale. Similarly, the machines being used at the farm need to be properly maintained and some individuals at the farm may even be asked to act as mangers that handle the paperwork and conduct the sale of the produce. Clearly, such a task would be more or less impossible for one person to handle if the farm is of any substantial size. To handle the farm more efficiently, labor needs to be hired and specialization areas need to be developed in order to ensure that the farm is operated efficiently. This process of dividing the labor to be done at the farm will cause greater returns and increase the overall productivity of the farm (Rodda, 2001). However, seeing that we have gained from adding one member to the labor team, we can add another to bring more specialization to the farm and allow the farm to further increase its output. However, the continued addition of more members to the labor pool would mean that each additional member brings in less value to the farm. While total productivity might be increasing, the average productivity would reduce measurably (Rodda, 2001). In fact, if we take the addition of farm labor to an extreme, at the 40th or perhaps the 400th addition to the team, the farm would probably start losing money since idle workers might actually interfere with production which reduces the output of the farm. Thus we have a few variables within the law of diminishing returns which include; the marginal physical product that is the amount by which output is increased when a worker is added to the labor pool and the average output which is calculated by dividing the total output by the number of workers. The situation for the farm described above can be represented in a table such as: No of workers Total Output Marginal Physical Product (MPP) Avg. Output 1 100 100 100 2 300 300 -100 = 200 150 3 900 900 - 300 = 600 300 4 1200 1200 -900= 300 300 5 1300 1300 -1200 = 100 260 6 1200 1200 -1300 = -100 200 Table 1: Law of Diminishing Returns As it is shown in the table, the increase in the labor pool from one to two workers results in a substantial rise in the total output and this is also seen when the number of workers is increased from two to three. However, the total output of the farm starts decreasing when the sixth worker is added and the average output per worker starts decreasing after the fourth worker is brought to work at the farm. The law of diminishing returns has been summed up in its entirety by Johnson (2005) as, “When increasing amounts of one factor of production are employed in production along with a fixed amount of some other production factor, after some point, the resulting increases in output of product become smaller and smaller (Johnson, 2005, Pg.1)”. Clearly in such a case, if we desire to further increase the output of the farm, other factors will need to be changed. Economies of Scale The idea of changing other variables of production along with labor leads to the concept of ‘economies of scale’. The application of the law of diminishing returns to one factor of production means that other factors of production have to be increased in either quantity or quality in order to improve the average output and the marginal returns. For example, if the farm was to add more land to its total holdings or if were able to get more/better machinery, then it is possible that the addition of more labor would not cause negative returns (Cannan, 1981). Consequentially, all factors may have to be increased in some ratio to get higher and higher levels of output. Thus a farm or any given company for that matter can have some advantages by operating at a large scale. These advantages include a lowered operation cost if the production and service facilities of the company are huge as compared to the other firms in the market. A real world example of an industry which achieves economies of scale by producing on a large scale is the automobile industry where manufacturers such as Ford or Toyota have huge production facilities. Even supermarket operators such as Wal-Mart obtain economies of scale by conducting their operations at a large scale. Once a firm has achieved the economies of scale, their production size allows them to compete on price since they have a larger profit margin and that scale itself acts as a barrier to entry for smaller firms (Cannan, 1981). In the real world, the idea of economies of scale can even be applied to farming as shown by the crisis in the agricultural sector of the Mexican economy which took place after NAFTA was implemented. The research done by Kacowicz, (1999) shows us that American agricultural producers worked with the application of the economies of scale and thus were able to produce large quantities of agricultural goods at a very low price. Their agricultural products were then sold in Mexico at price points which did not allow small farmers in Mexico to compete with them. The American agricultural output dominated the Mexican agricultural output which put many Mexican farmers completely out of business. In fact, the situation has got to the point that a substantial number of Mexican farmers left their farmland to look for job opportunities in urban centers. In conclusion, both the Law of Diminishing Returns and the idea of the economies of scale are important concepts for economists since they give some guidelines on how a firm can be competitive with others. Of course they also point towards ideas which support monopolies for economic efficiencies yet there are social and legal requirements which may prevent monopolies from coming into shape. However, that does not remove the applicability of the concepts or their usefulness in economic theory. Word Count: 1,629 Works Cited Cannan, E. 1981, A Review of Economic Theory, Routledge. Johnson, P. 2005, ‘Diminishing returns, law of’, Aubrun University, [Online] Available at: http://www.auburn.edu/~johnspm/gloss/diminishing_returns_law_of Kacowicz, A. 1999, ‘Regionalization, globalization, and nationalism: Convergent, divergent, or overlapping?’, Journal of Social Transformation & Humane Governance, vol. 24, no. 4. pp. 527-556. Rodda, C. 2001, ‘Law of Diminishing Returns’, Dircon.co.uk, [Online] Available at: http://www.cr1.dircon.co.uk/TB/2/dreturns.htm Read More