Diminishing returns is probably one of the most important concepts in Economic theory. It is so famous that it has now entered common everyday speech. Some people do get confused with diminishing returns but it is actually quite a simple idea.
What are Diminishing Returns?
One simple way of explaining diminishing returns would be to say that more isn’t always better. Or to put it another way, there will be a stage in production when further increases will lead to diminished returns. To understand this you need to know a little bit about the factors of production; labor is one factor of production and equipment is another. Diminishing returns occurs when you increase one factor of production; there will come a point when increasing this factor won’t increase overall output. This can sometimes sound a bit confusing so it is probably best to provide an example.
Imagine that you are the owner of a factory that makes umbrellas. To make these umbrellas you need three factors of production; labor, resources, and industrial equipment. Now imagine your workforce is made up of one employee and you have one machine for making umbrellas. You can also imagine that your storage space is jammed packed with all the materials to make the umbrellas. Now imagine that your employee is able to use the machine to its maximum capability and produces 100 umbrellas during his eight hour shift. Not bad — your worker is getting the most productivity out of the machine in the limited amount of time he has.
Now imagine you decide that you are no longer happy with one hundred umbrellas and you want to increase one of the factors of production. You decide to hire another employee to work another eight hour shift. You now have the machine working 16 hours a day and producing 200 umbrellas. If you get another employee to work another 8 hour shift you can have the whole twenty four hours covered and 300 umbrellas produced every day — great stuff. What would happen though if you were to employee a new member of staff? Well, the fact that the machine has already reached its capacity means that you won’t get any more umbrellas and the cost of each unit will actually rise because of the increased labor costs. You have now hit diminishing returns. If you were to add even more staff they could then start getting in each other’s way and you will see returns further diminish.