On Tuesday night, feeling lazy, you decide to skip making dinner and grab some Chinese food.
In a visceral demonstration of poor judgment you order a dozen eggrolls, chatting with the cashier about your resolution to lose weight while waiting for them to fry up. He rings up one "cry for help special."
Back at home you eat one eggroll, and it's delicious. You eat another. It's still pretty good. By the fourth eggroll… well, it tastes like you've eaten four eggrolls in a single sitting. By the fifth things have gotten weird.
This is diminishing returns dressed up in a gallon of duck sauce.
What Are Diminishing Returns?
Also called "diminishing marginal productivity," the law of diminishing returns has both a casual application and a formal one. They are related, but not quite the same.
Casually, the law of diminishing returns is the idea that the more you use something, the less value you get from it. Take our eggrolls from above. The more you eat, the less you enjoy them. You see diminishing returns.
The critical difference is that in casual use we refer to diminishing returns only as "getting less out of each new thing." We don't enjoy the first eggroll any less for having decided to eat 11 more. As discussed below, formal use says that the entire system becomes less efficient, including eggrolls both past and present.
Now here's the technical definition: Diminishing returns is a principle of economics. It says that in any system of production, there comes a point where increasing the quantities of one input while holding all other inputs constant yields progressively smaller output results. This point is called the "optimal result."
Once you've reached the optimal result, the only way to maintain your previous gains in output is by increasing the size of the entire system.
Example of Diminishing Returns
Consider a store filled with shoppers. In this situation there's a certain number of salespeople who will yield an optimal result for sales. Below the optimal number of salespeople, customers are frustrated. They have to wait for attention and may wander off. We need to hire more salespeople. Since we have an excess of customers, each salesperson hired can work full time and increase sales by the same amount.
However, eventually we reach our optimal result where every customer who wants a salesperson can find one immediately. Past that point new salespeople don't lead to as many new sales. They stand around idle. We're overstaffed and our sales per employee drops. We have reached a point of diminishing returns.
What Is An Optimal Result?
The law of diminishing returns depends on the concept of an optimal result. This is the idea that at a certain point all productive elements of a system are working at peak efficiency. You can't get any more efficiency from the system because everything and everyone is working at 100%.
Note that past this point it may be possible to get more output from the system. However, if so, you will see smaller and smaller gains for similar units of input.
A system of production has three states surrounding the optimal result:
1. Below Optimal
Here, the system is underutilized. Certain elements of the system are working inefficiently and could produce more output if they had more materials to work with. By increasing one or more inputs you can get more out of your system.
The system is producing at full efficiency. This means that no elements of the system are idle or under-utilized. Each given unit of input is used as fully as possible to create a unit of output.
3. Diminishing Marginal Productivity
The system might produce more than at optimal state, but one or more elements are operating inefficiently. This means that some unit of input has been oversupplied. The other elements of your system can't use all of that input, and so you see increasingly diminishing returns.
Past the point of optimal results, the only way to maintain your system's efficiency while also increasing production is to expand your system overall.
Example of Optimal Results
Let's return to our shop to look at optimal results in action.
1. Below Optimal
Our store is understaffed. This makes the customer element of our system operate inefficiently. They can't always find a salesperson to speak with when they'd like to buy something.
In economic terms, our salespeople are operating at 100% efficiency because each one spends all of his time speaking with a customer and contributing to the output (sales). Our customers, however, are operating at less than 100% efficiency because each one spends time unable to find a salesperson and buy something.
Our store has exactly the right amount of staff. Every customer can find a salesperson with ease. Every salesperson is constantly engaged with selling something.
Both inputs are now operating at 100% efficiency. Our salespeople are always interacting with customers to close a sale, our customers can always find a salesperson to buy something.
3. Diminishing Returns
Our store is overstaffed. Although every customer can always find a salesperson, many of those salespeople go long stretches of time without speaking with a customer.
Our salespeople have become less efficient. Each new hire increases the employee-to-customer ratio and the amount of time those salespeople spend just standing around. Our customers still operate at 100% efficiency, but they have all the help they need. They've got no use for the additional salespeople lingering around.
The only thing we can do now is to expand the entire store and get more customers in.
Diminishing vs. Negative Productivity
There are two main results for passing the point of diminishing returns.
The more input you add to the system the smaller your margins of output become. You may still see gains in production, it simply becomes harder and more costly to generate the same additional output.
Returning to our store example, let's say that we have reached our optimal point of staffing. By adding new salespeople we might continue to increase sales, perhaps our more crowded sales floor makes it easier for shoppers to grab an impulse buy. However, we won't see gains like we used to.
If peak efficiency staff sees an extra $10,000 in sales for each new employee, diminished productivity staffing may only generate an extra $5,000 per new hire. Then only $2,000 for the salesperson after that, and $1,000 for the salesperson after that and so on. (Readers will note that in doing so, we have made our entire salesforce less efficient overall. The team used to average $10,000 per person and with each new hire we will reduce this.)
It is possible for diminishing returns to lead to a negative productivity curve as well. This happens when adding new input to the system doesn't simply reduce the system's efficiency, it reduces the system's output overall.
Back to our store again. Let's say we have a customer base that feels easily harassed. In that case they might not simply ignore the extra staff we have lingering around, they might get upset by it. By having idle salespeople with nothing better to do than poke and prod at the customers we may actively drive some from the store, reducing our sales overall.
The Diseconomy of Scale
The law of diminishing returns can overlap with the concept of diseconomy of scale. While outside the scope of this piece, we will touch on it briefly.
Economy of scale is the idea that as output grows, costs per unit of output can go down.
For example, you own and operate a printing shop. It might cost you $500 in materials and labor to produce a single poster for someone, including buying a full ream of paper. However, printing 500 of them will reduce that cost to only $1 per poster because you already have the supplies and printing new posters will require negligible additional labor.
Diseconomy of scale is the point when that curve reverses. As output continues to grow, costs per unit of output begin to go back up.
Let's say your customer asks for 501 posters. At the 501st printing, you need to go out and buy a new ream of paper to print only one additional poster. This additional unit of output has pushed your average cost per poster back up.
This is distinct from diminishing returns. Diseconomy of scale focuses on average cost measured as a function of output, and it measures what happens to the system as you increase that output. Diminishing returns focuses on the costs per unit of input and the ability of a system to efficiently use each unit of input plugged in. They are conceptually related, but distinct.
History of Diminishing Returns
Understanding diminishing returns is essential to most business ventures. In fact, it's a part of everyday life, such as the phrase, "work smarter, not harder." At a certain point, pouring more hours into a project won't help if there's something else missing.
Or, for our friend with the dozen eggrolls up top, at a certain point it's essential to realize that eating more fried Chinese food will not keep making him any happier. (That point is after the first eggroll, in case readers were curious.)
Historically, economists were also concerned that diminishing returns would lead to global misery and the erosion of human civilization. They saw the application of diminishing returns to farmland, and noted that at a certain point any given acre of land has an optimal result of food output per worker.
The human population, they noted, will continue to grow while the amount of arable land will not. This means that at a certain point all available farmland will reach its optimal result, and each new person will produce less and less food to feed themselves with. Eventually the population would outgrow its ability to feed itself.
Fortunately, these economists did not foresee the development of technology that would increase farming output. They were right, however, about the law of diminishing returns.