Law of Diminishing Marginal Returns

The law of diminishing marginal returns states that, at some point, adding an
additional factor of production results in smaller increases in output. For example, a
factory employs workers to manufacture its products, and, at some point, the company
operates at an optimal level. With other production factors constant, adding additional
workers beyond this optimal level will result in less efficient operations.
Understanding the Law of Diminishing Marginal Returns
The law of diminishing marginal returns is also known as the law of diminishing
returns, the principle of diminishing marginal productivity, and the law of variable
proportions. This law affirms that the addition of a larger amount of one factor of
production, ceteris paribus, inevitably yields decreased per-unit incremental returns.
The law does not imply that the additional unit decreases total production, which is
known as negative returns; however, this is commonly the result.
Important: The law of diminishing marginal returns does not imply that the
additional unit decreases total production, but this is usually the result.
The law of diminishing returns is not only a fundamental principle of economics,
but it also plays a starring role in production theory. Production theory is the study of
the economic process of converting inputs into outputs.
KEY TAKEAWAYS
The law of diminishing marginal returns states that adding an additional factor
of production results in smaller increases in output.
The addition of a larger amount of one factor of production inevitably yields
decreased per-unit incremental returns, the law says.
The law of diminishing marginal returns is also known as the law of diminishing
returns, the principle of diminishing marginal productivity, and the law of variable
proportions.
Relationship Between the Marginal Physical Product & Marginal Cost
The relationship between the marginal product of labor and the marginal cost
helps determine whether it is worthwhile to produce additional products. The marginal
product of labor refers to the number of products a company can manufacture if it hires
more workers or assigns its current workers additional hours. The marginal cost refers
to the amount it costs a company to produce each additional item.
Marginal Product of Labor
The marginal product of labor varies depending on the number of products a
company is currently making. When the company doesn't have enough workers to use
all of its equipment, an extra worker can produce many more items with its current
equipment, so the marginal product of labor is high. If the company has more workers
than available machines, it won't gain much by hiring additional employees, so the
marginal product of labor is lower, which is known as the law of diminishing returns.
Marginal Cost
The marginal cost determines how much it costs to make each additional item.
Marginal cost includes the marginal product of labor and the marginal cost of materials.
The company may have to pay more money if it orders more materials, because its
suppliers may only have the capacity to supply a small amount of raw materials at a
low price and may have to pay its workers overtime or hire additional workers to
provide more.
Units
Marginal product of labor and marginal cost use different units. The marginal
product of labor uses one labor unit, which does not have a specific definition. One
definition of a labor unit is days worked, so a company can calculate the marginal
product of labor as the number of products that all workers produce during one work
day. Marginal cost is specific and refers to the amount it costs the company to produce
one more inventory item.
Significance
As the marginal product of labor decreases, the marginal cost usually increases.
If the company has to pay more money to each worker compared with the number of
products that each worker makes, its labor cost for each item increases, so its cost to
make each item will be higher. The marginal cost can only decrease when the marginal
product of labor is falling if the company is spending less per item on additional
materials than the extra amount that it is paying to its workers, which can happen if it
gets a bulk purchase discount on materials.
Relation between Average, Marginal and Total Cost
1. Relation between Average Cost and Marginal Cost:
Relation between average cost and marginal cost is explained through Table 8
and Fig. 9.

Table 8 and Fig. 9 offer the following observations with regard to the relation between
average cost and marginal cost:
(1) When AC Falls, MC is Lower than AC:
When average cost falls, marginal cost is less than AC. In Table 8, AC is falling till it
becomes Rs.8, and MC remains less than Rs.8. In Fig. 9, AC is falling till point E, and
MC continues to be lower than AC. In this case, marginal cost falls more rapidly than
the average cost. That is why when marginal cost (MC) curve is falling, it is below the
average cost (AC) curve. It is shown in Fig. 9.

(2) When AC Rises, MC is Greater than AC:

When average cost starts rising, marginal cost is greater than average cost. In Table 8,
when AC rises from Rs.8 to Rs.9, MC rises from Rs.8 to Rs.16. In Fig. 9, AC starts rising
from point E. And, beyond E, MC is higher than AC.

(3) When AC does not Change, MC is Equal to AC:

When average cost does not change, then MC = AC. It happens when falling AC
reaches its lowest point. In Table 8, at the 7th unit, average cost does not change. It
sticks to its minimum level of Rs.8. Here, marginal cost is also Rs.8. Thus, Fig. 9 shows
that MC curve is intersecting AC curve at its minimum point E.

2. Relation between Total Cost and Marginal Cost:

Table 8 and Fig. 11 offer the following observations with regard to the relation between
total cost and marginal cost:
(i) Marginal cost is estimated as the difference between total costs of two successive
units of output. Thus,
MCn = TCn – TCn-1
(ii) When MC is diminishing, TC increases at a diminishing rate.
(iii) When MC is rising, TC increases at an increasing rate.
(iv) When MC reaches its lowest point (point Q in Fig. 11), TC stops increasing at a
decreasing rate (point Q* in Fig. 11).
Briefly, MC is the rate of TC.