Diminishing returns is an economic principle that theorises about the relationships between an increase in the number of employees and a reduction in productivity.
According to this principle, an increasing number of new employees causes the productivity of another employee to be smaller than the productivity of the previous employee at some point.
Business managers need to understand the principle of diminishing returns, since increasing employee numbers can, counter intuitively, become a detrimental factor affecting inventory management, among other things. In this article, we explain what diminishing returns are and how they may affect your business decisions.
What are diminishing returns?
The law of diminishing returns states that in a productive process, adding in more of a single factor of production results in decreasing per unit returns. In other words, increasing one factor of production several times results in a smaller increase in production each time.
As total input increases following an increase in just one factor of production, the total output as a proportion of the total inputs decreases. Essentially, output responds poorly to increasing one particular input.
Origins of diminishing returns
Diminishing returns is also known by other names, including the law of diminishing returns, the principle of diminishing marginal productivity and the law of variable proportions. The principle of diminishing returns originated as early as the mid-1700s, economist Jacques Turgot being one of the first to use the term.
Other early economists such as Robert Malthus and David Ricardo suggested that diminished productivity resulted from a decrease in the quality of input. For example, Riccardo demonstrated how additional labour and capital to a fixed piece of land would successively generate smaller output increases over time.
Later classical economists have suggested that each “unit” of labour is exactly the same, and decreases in productivity – diminishing returns – are caused by a disruption of the entire production process as extra units of labour are added to a set amount of capital.
The basics of diminishing returns
The law of diminishing returns suggests that the addition of a larger amount of one factor of production, while all others remain constant, inevitably yields decreased per-unit incremental returns.
To illustrate, imagine that a factory employs numerous workers to manufacture their products. So long as all other factors of production remain the same, the increase in the number of employees will see each additional worker generating less output than the worker before him.
So, as a company employs more workers, each additional worker becomes less productive and provides smaller and smaller returns. If the company continues to employ more and more staff, eventually the factory will become so cramped that the increase in numbers may actually begin to hinder production.
Therefore, in this scenario a company may experience diminishing returns by way of reduced productivity. Adding too many workers can inhibit the efficiency of the production process, thereby reducing productivity.
This is a key factor affecting inventory management which managers should take into account when considering employing additional staff members.
Diminishing returns and inventory management
Understanding how the principle of diminishing returns works is important for companies, since increasing production through hiring more staff may end up being counterproductive.
Common sense suggests that the more staff you have, the more product you can make and the more you can sell.
However, unchecked employment increases may have little effect on productivity, and may even reduce it.
How do diminishing returns affect product costs?
The price that your business charges will usually reflect your average total cost of production and, perhaps more relevantly, the average cost of goods actually sold.
Average total cost is the total production cost spread across the total number of units produced. Increasing one or several factors of production even where returns are diminishing will increase your average total cost which, in turn, is likely to increase the cost of goods sold.
To compensate for this increase in cost, you may need to increase price levels, noting, of course, that this is likely to reduce sales volumes.