Diminishing Marginal Returns vs. Returns to Scale: An Overview

Diminishing marginal returns are an effect of increasing input in the short run while at least one production variable is kept constant, such as labor or capital. Returns to scale are an effect of increasing input in all variables of production in the long run.

Diminishing Marginal Returns

The law of diminishing marginal returns states that with every additional unit in one factor of production, while all other factors are held constant, the incremental output per unit will decrease at some point. The law of diminishing marginal returns does not necessarily mean that increasing one factor will decrease overall total production, or result in negative returns, but this outcome is nevertheless a common one.

Reducing the impact of the law of diminishing marginal returns may require discovering the underlying causes of production decreases. Businesses should carefully examine the production supply chain for instances of redundancy or production activities interfering with each other.

For example, a firm hiring more employees while keeping the same office space can increase total output, but every additional employee produces less additional output than the one before him. The total output can decrease at some point, resulting in negative returns if, for instance, the same firm hires too many employees who get in each other's way and eventually become unproductive.

Reversing the law of diminishing returns, if production units are removed from one factor, the impact on production is minimal for the first few units and may realize substantial cost savings. For example, if a firm removes a few employees rather than hiring more, it may realize cost savings without experiencing significantly diminished production.

Reducing the impact of diminishing marginal returns may require discovering the underlying causes of production decreases.

Returns to Scale

On the other hand, returns to scale refers to the proportion between the increase in total input and the resulting increase in output. There are three kinds of returns to scale: constant returns to scale (CRS), increasing returns to scale (IRS), and decreasing returns to scale (DRS). Decreasing returns to scale is when all production variables are increased by a certain percentage resulting in a less-than-proportional increase in output.

For example, if a soap manufacturer doubles its total input but gets only a 60 percent increase in total output, then it can be said to have experienced decreasing returns to scale. If the same manufacturer ends up doubling its total output, then it has achieved constant returns to scale, where the increase in output is proportional to the increase in production input. Increasing returns to scale, meanwhile, occurs when the percentage increase in output is higher than the percentage increase in input.

Key Takeaways

  • Diminishing marginal returns is an effect of increasing input in the short run while at least one production variable is kept constant, such as labor or capital.
  • Returns to scale is an effect of increasing input in all variables of production in the long run.
  • Reversing this law, if production units are removed, the impact on production is minimal for the first few units and may realize substantial cost savings.