Question

What are diminishing marginal returns?

Short answer

Diminishing marginal returns is an economic principle stating that as one input (e.g., labor or capital) increases while other inputs (e.g., land or technology) remain constant, the additional output produced by each new unit of the increased input will eventually decrease. This concept helps businesses understand how increasing resources can lead to a decrease in overall efficiency and productivity, requiring them to optimize input levels. For example, in a pizza business with a fixed number of ovens and kitchen space, hiring more chefs initially increases pizza production substantially, but eventually, each additional chef contributes less to output due to limited resources, leading to diminishing marginal returns.

Step-by-step solution

Definition of Diminishing Marginal Returns

Diminishing marginal returns is an economic principle that states that once one input (like labor or capital) is increased while other inputs (like land or technology) are held constant, the additional output produced from each new unit of the increased input will eventually decrease. In other words, as more and more of one input is used to produce something, it will yield less and less incremental output.

Importance and Explanation

Understanding diminishing marginal returns is important because it helps to explain why businesses may face diminishing returns when increasing their workforce, investing in more machines, or utilizing more resources. As a result, they must find the optimal level of input to maximize their benefits without facing a decrease in overall efficiency and productivity.

Example of Diminishing Marginal Returns

Let's consider a pizza business that wants to increase its production to meet the growing demand. The business has a fixed number of pizza ovens and kitchen space. To increase production, they decide to hire more pizza chefs. Initially, with each additional chef hired, the output (number of pizzas made) increases by a large margin, as each chef can make several pizzas at the same time (without interfering with the work of others). However, after hiring a certain number of chefs, each additional chef hired will contribute less and less to the increase in pizza production. This is because kitchen space and oven availability becomes limited. Eventually, hiring even more chefs might even decrease the total number of pizzas made, due to overcrowding and inefficient use of resources. In this example, diminishing marginal returns occur as more chefs are added to the fixed pizza ovens and kitchen space, leading to a decline in the additional output (pizzas made) contributed by each new chef.