Diminishing Marginal Returns vs. Returns to Scale: An Overview

In business, it is important to reach a level of optimal production. This ensures that all factors of production are being used in their best capacity. Making adjustments to the factors of production, or inputs, has varying effects and can be analyzed in different ways.

Diminishing marginal returns is an effect of increasing input in the short run after an optimal capacity has been reached while at least one production variable is kept constant, such as labor or capital. The law states that this increase in input will actually result in smaller increases in output. Returns to scale measures the change in productivity from increasing all inputs of production in the long run.

Key Takeaways

  • Diminishing marginal returns is an effect of increasing an input after an optimal capacity has been reached leading to smaller increases in output.
  • Returns to scale measures the change in productivity after increasing all inputs of production in the long run.
  • Under the law of diminishing marginal returns, removing inputs to a point can result in cost savings without diminishing production.
  • There are three types of returns to scale: constant returns to scale (CRS), increasing returns to scale (IRS), and decreasing returns to scale (DRS).

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, which would be negative returns, but this outcome usually occurs.

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 restaurant hiring more cooks while keeping the same kitchen space can increase total output to a point, but every additional cook takes up space, eventually leading to smaller increases in output as there are too many cooks in the kitchen. The total output can decrease at some point, resulting in negative returns if too many cooks get in each other's way and eventually become unproductive.

By 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 result in substantial cost savings. For example, if a restaurant removes a few cooks rather than hiring more, it may realize cost savings without experiencing significantly diminished production.

Reducing the impact of diminishing marginal returns requires 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).

A constant returns to scale is when an increase in input results in a proportional increase in output. Increasing returns to scale is when the output increases in a greater proportion than the increase in input. 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 40% 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. If the output increased by 120%, then the manufacturer experienced increasing returns to scale.

Key Differences

Though both diminishing marginal returns and returns to scale look at how output changes are affected by changes in input, there are key differences between the two that need to be considered.

Diminishing marginal returns primarily looks at changes in variable inputs and is therefore a short-term metric. Variable inputs are easier to change in a short time horizon when compared to fixed inputs. As such, returns to scale is a measure focused on changing fixed inputs and is therefore a long-term metric.

Both metrics show that an increase in input will increase output up until a point, the main difference between the two is the time horizon and therefore the inputs that can be changed: variable or fixed. Understanding both and their differences is important for firms in their decision-making process to reach optimal levels of production and cost efficiency.