There are several economic concepts that entrepreneurs should consider when producing goods. The law of diminishing marginal productivity is one of them.
In simple words, it helps determine the point after which the utility of the product unit decreases. However, the whole concept is not that simple, so we’ve designed this guide for you to learn all the ropes.
What is the law of diminishing marginal productivity?
This law states that the utility of the product unit decreases as the quantity increases. If we increase the variable input unites along with fixed inputs, we will notice the following trend in the overall output:
At first, it will grow at a growing rate; then, it will shift to a declining rate.
If we project this law to a production process, in parallel to increases in consumption levels, the marginal utility of each consumed product will be less than that of the previous one.
What is utility?
It’s the level of satisfaction or happiness of a consumer from using a specific product. In other words, utility describes the extent to which our consumed products add value or are helpful for us.
What does marginal utility hint us?
Having said that utility of the product decreases when increasing the production quantities, you can guess that at some point, the marginal utility may turn to a declining utility. In other words, there will be no need to consume a particular product after a specific quantity, as it will stop adding value.
In parallel to declining utility, the price of a product unit decreases because consumers are not willing to pay for a product that does not carry a new value for them.
This is one of the key reasons why entrepreneurs should consider the law of diminishing marginal productivity, as, at some point, consumers will not be willing to buy a product at a price that is profitable for the manufacturer.
An example of grasping it better
Let’s say it’s the hottest summer afternoon, and you are walking along the street in search of some cold drink. As you want to satisfy your thirst, you will most probably stop at a cafe nearby to buy some drink, even if you find the drink more expensive than you will be willing to pay for.
As you drink the first cup, and your thirst is more or less satisfied, you are less likely to buy a second cup with the same price, as your thirst becomes bearable after the first cup. This is a real example of the diminishing utility of the product that happens as the quantity of the consumed product item increases.
Why is a law of diminishing marginal productivity useful for businesses?
The concept of marginal productivity helps businesses to understand the point after which there is no worth in increasing the production factors, such as raw materials, labor hours, and machine hours.
This point can be different for each specific industry and company. Therefore let’s learn how the companies usually determine it. But to do so, we need to jump into another economic concept tightly related to the law of diminishing marginal productivity; diminishing returns.
What is the point of diminishing returns?
The point of diminishing returns is a concept in microeconomics that helps determine optimal production capacity for enterprises. After that point, adding new production points is not justified, as it results in smaller output and is not profitable.
Therefore, the point of diminishing returns is where the production is at its most effective phase.
Since the production process occurs due to several production factors, the point of diminishing returns is different for each production factor.
This means companies need different levels of raw materials, labor hours, and machines to maximize their production capacity.
Let’s say you produce T-shirts. To do so, you invest in fabric and other raw materials. You also hire sewists, buy sewing machines, printers, and other required machines.
You might need to increase your production and buy a few new machines at some point. This will push your production volumes forward at first, as more machines allow you to produce more T-shirts. However, at some point, your current employees’ capacity might not be enough to work on all your new machines, and each new piece of equipment will start producing fewer T-shirts, as employees will not be able to properly use all the equipment’s capacity.
This means that merely investing in production equipment will result in less output than before, and you should stop buying equipment unless you don’t increase the other production factor – labor.
So, the point after which each equipment started producing fewer units than before is the point of diminishing returns.
How to find diminishing returns?
To find out the point of diminishing returns, you must first construct your return function. Let’s assumes its R = -4×3 + 36×2 + 70 in our case.
Mathematically, the point of diminishing returns is when the return function’s second derivative equals zero.
In our case, R’’ = -24x + 72, so x=3
Therefore, our point of diminishing returns will equal to -108 + 324 + 70 = 286
This means the maximum level of productivity for this production factor is when you have 286 production inputs.
The law of diminishing marginal productivity in business
Both the law of diminishing marginal productivity and the point of diminishing returns can help companies to plan their production investments. It’s beneficial for organizations that want to increase their products continuously.