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What is the 'Law Of Diminishing Marginal Productivity'

The law of diminishing marginal productivity is an economic principle that states that while increasing one input and keeping other inputs at the same level may initially increase output, further increases in that input will have a limited effect, and eventually no effect or a negative effect, on output. The law of diminishing marginal productivity helps explain why increasing production is not always the best way to increase profitability.

BREAKING DOWN 'Law Of Diminishing Marginal Productivity'

Marginal productivity refers to the extra output yielded by an additional unit of input. Inputs are most often labor, but they could also be components or raw materials. The law of diminishing marginal returns states that when a factor of production is fixed, there is a point at which an increasing volume of variable factors will become less productive. This means that each additional unit of input will produce less output than the prior unit of input. Diminishing marginal productivity results from rising short-term average costs. Firms can address issues related to rising short-term average costs by reducing output to an optimal level or increasing other factors of production. These measures can ensure profit maximization.

Diseconomies of Scale

Diminishing marginal returns should be distinguished from diseconomies of scale, which are the result of rising long-term average costs. These problems occur because a firm grows too large to continue operating efficiently, and administrative inefficiencies are usually at the core of this. Poor communication among departments, duplicative roles, lack of oversight over employee behavior, and bloated managerial structure all generate expenses that would not be incurred by smaller organizations. These do not necessarily indicate any problem with marginal profitability, because diseconomies of scale can be wholly unrelated to productive activities.

Example

Consider a factory that produces a product called a widget. The factory uses the same amount of electricity to produce zero to 100 widgets, but the machinery functions less efficiently if it is overworked. The electricity consumed by the factory's machines increases exponentially from 101 widgets and higher. Marginal productivity rises as output approaches 100 widgets, because higher volumes can be produced and sold without incurring extra production expenses. However, after the 100-unit mark is breached, production costs start to rise more quickly than output volume. Eventually, the exponentially rising electricity costs will overtake the profits generated by each widget.

The company should explore other options, even if it must reduce its volume output. Alternatively, the company could purchase and deploy additional machinery, which would consume less electricity per unit.

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