Diminishing Returns – Commonly Discussed, Yet Still Mystifying

Overview – More Input Leads to More Output, Right?

“Diminishing returns” is commonly cited in all sorts of discussions, ranging from investment analysis all the way to how much a student needs to study for an exam.

While most people have a general understanding of what it is, many of them do not understand the full, economics-based explanation behind it: why it happens, why it’s a problem, and how to stop it.

In this article, we will go over what the concept of diminishing returns is, and why investors should also be aware of it.

Time Period and Factors of Production

Before understanding how diminishing returns works, we must first understand under what circumstances the law applies.

The major variable that contributes to diminishing returns is the time period. Time periods, in an economics context, can either be short-run or long-run.

Over the short-run, at least one of the factors of production is fixed (e.g., a fixed amount of farmable land, a fixed amount of assembly plants, etc). Fixed factors of production are inputs that cannot be changed during the production process. Whenever a fixed factor is present, this indicates a short-run production process.

On the other hand, variable factors are those that can be increased during production, for example, bringing in more workers or adding more assembly lines. The long-run is a period of time in which all the inputs of production are variable.

Fixed factors of production only exist in the short-run. Long-run production processes do not have fixed factors.

Two additional factors we’ll also need to look at are total product and marginal product.

Total Product and Marginal Product

Diminishing returns is all about studying how total product and marginal product change as inputs are increased.

Total Product (TP) is the total output produced by the inputs of a productive process. Common sense may dictate that as inputs increase, so should the total product, however, this may not always occur.

Marginal Product (MP) is the change in the total product as one more unit of input is added to the production process. Marginal product measure how much another unit of input contributes to the total production.

The marginal product can be expressed in equation form as:

Diminishing Returns Example: Microchip Production

Shown below is a table of a microchip production schedule. This table will be used to explain what diminishing returns is.

Microchip Production Schedule

Notice that when more than four workers are added to the microchip production process, the marginal product starts to fall and continues to go down, seemingly forever. In fact, the marginal product even becomes negative, starting with worker #10.

This observation of marginal product continuously decreasing is diminishing returns in action.

The Law of Diminishing Returns

The law of diminishing returns states that as an increasing amount of a variable factor is added to a fixed factor, the marginal product will decrease for each unit of variable product added.

This short statement is a bit deceptive, so let’s carefully analyze the meaning.

Variable factors are being added to a fixed factor, so diminishing returns only apply to the short-run (remember, the short-run means at least one fixed factor is present). Diminishing returns does not occur if every factor is variable, or in other words, it doesn’t happen in the long-run.

In the example above, if an additional assembly facility was added as the total number of workers increased, then diminishing returns would not be observed.

Also, the law does not specify when diminishing returns will start to happen, only that it eventually will, assuming that the production process happens in the short-run.

So why does this law make sense?

Why The Law of Diminishing Returns Makes Sense

Common sense would dictate that as we add more inputs to a production process, the more output we’ll get. In the microchip production schedule shown above, we see that this is indeed the case, but only up to a certain point. Why is that?

Because a fixed factor exists, the production process has a finite capacity to accommodate more inputs. Past a certain point, the additional inputs aren’t contributing to production at all because they don’t have the ability to.

In our above example, we only have one assembly facility. A facility assembly only has a limited number of machines, tools, and workstations available for workers to use.

We start the production process with zero workers, but for every additional worker we add, they start to use the assembly facility’s limited supply of machines, tools, and workstations. Assuming there are unused resources at the assembly facility, getting another worker to use them will increase production.

However, past a certain point, all of the resources at the facility will be used. Any additional workers that are added won’t be as productive because they have nothing to use, or are forced to share with other workers. Add too many and you’ll soon have a bunch of people just standing around doing nothing.

This is why any time you have a fixed factor of production, diminishing returns is inevitable. Your production process is only as productive as your fixed factor’s maximum productive capacity.

Now, assuming you had the ability to add more assembly facilities, then diminishing returns wouldn’t be a problem: as you hire more workers, you simply construct more facilities to accommodate them, so your marginal production continues to go up.

However, you can only construct so many assembly facilities until you run out of space to put them or you run out of money to create them.

Theoretically, the only way you could defeat this law is to have an infinite capacity to add more factors to your production process, but in the real world, this isn’t the case at all.

Even the largest companies have a finite amount of capital to spend, and even if they had limitless capital there are only so many places in the world they can set up a new facility.

Therefore, if you don’t find a way to increase all your factors of production, diminishing returns isn’t a matter of if, but when.

So what does this all mean for investors?

What This Means for Investors

Diminishing returns serves as a reminder to investors that spending more time on certain tasks will only get them so far in advancing their work. Past a certain point, exerting any more effort simply isn’t worth it.

A classic example is investment analysis.

Generally speaking, it’s true that more time spent analyzing documents such as annual reports and financial statements will usually yield more insight, but eventually, you will have already looked at all the major bits of information that contribute the most to your analytical work.

Any additional time you spend on analysis won’t benefit you nearly as much because whatever information is left is usually very minor. If you want to keep performing analysis, your best bet is to find other sources of information.

Even if you do use more sources of information, you’ll eventually reach the point where there’s nothing new for you to learn since you already know about it from previous sources.

Or imagine you want to look for investments in the tech industry. At first, you may find some very good opportunities, but eventually, you will have gone through all the low-hanging fruit. Any additional tech prospects will take a lot more digging to uncover, assuming there are any left for you to find.

At that point, you’re better off diversifying your search to other industries if you’re still shopping around for investment opportunities.

Every investor has at least one thing in common, and that is they all have a limited amount of time. Therefore, they can’t afford to spend exorbitant amounts of it trying to squeeze out ever smaller gains.

Don’t forget the 80/20 rule: 80% of your output/results will come from 20% of your input/effort. You don’t need to know everything about a prospective investment or scour an entire industry: eventually, you’ll reach the point where the only thing you’re doing is wasting your precious time.

Wrapping Up

Diminishing returns is a relatively simple concept with very profound implications. Whenever a fixed factor is present and a variable input is continuously being added, then it’s only a matter of time before diminishing returns sets in.

The only way to defeat diminishing returns is to make every factor of production variable. This sounds great but only works in theory. In the real world, nobody has access to infinite resources, so there will always be a fixed factor present. Therefore, diminishing returns is never a matter of if but always a matter of when.

Unfortunately, investors may inevitably run into diminishing returns as well. Every investor has a limited amount of time, so they can’t afford to waste it as they chase ever smaller gains. Part of being an investor is understanding when more action won’t result in significantly more benefits.

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